Interest is the price paid for the use of capital. Capital ay be either in the from machines and tools or in monetary is. Generally money capital is borrowed for the purchase of machinery and other producer good. As money is borrowed, interest it is usually paid in monetary terms.
Interest is the price paid the use of borrowed funds. A borrower invests the capital are s interest to the lender. What the lender receives as interest is the gross interest. He has to deduct many things from interest in order to arrive at the net profit. Net profit is the actual price for the use of capital.
Why is interest paid?
Payment of interest for the use of borrowed fund is necessary for different reasons. Different economists are of various opinions as to why a lender deserves the interest in lie of borrowed fund. J.B.Say, J.S. Mill, Marshall, Bhum-Bawerk, fisher and Keynes have given their views on the necessity of paying interest.
(1) Interests paid for waiting and abstinence of percent consumption:-
According to the classical economists interest is the reward for the abstinence of present consumption. A lender saves money only when he scarifies his present consumption. He undergoes displeasure by postponing his present consumption.
So the lender is worthy of getting interest as he abstains from present consumption. This reward or interest is paid to compensate his present loss of money. Without interest no lender will be induced to lend his saving as borrowing.
The idea of abstinence was criticized by Karl Marx. He said that the rich people are the main source of capital. They save not by curtailing their present consumption. Their saving constitutes their surplus income.
They never save to earn interest rather they save because they are left with residual income after the consumption of their hearts desire. Marshall said that it is not the abstinence of present consumption but it is the waiting involved in the process of saving which is the cause of paying interest on borrowed funds.
When a person saves his consumption is not curtailed rather his consumption is postponed. A saver waits to create lonable fund. When he lends this fund he takes certain reward for the sacrifice of waiting. Thus to Marshall Interest is paid for waiting.
(2) Interest is paid because of time preference:-
According to Irving Fisher time preference is the cause of interest payment. To him people prefer present enjoyment of goods to future enjoyment. Thus in order to induce them to save for future instead of present enjoyment the borrower pays interest. Thus time preference means the preference of present enjoyment over future enjoyment. The inclination for present enjoyment makes people impatient to spend their incomes in the present.
According Fisher interest is a compensation for the time preference of the individual. The greater the degree of -impatience for present, the higher will be the rate of interest. The degree of impatience of spend income -in the present depends on the size of a personals income, the degree of certainty regarding the enjoyment of future etc.
As the rich people are fully accomplished their impatience for present is relatively less and thus they discount the future at lower rate of interest on the other hand poor people seek higher interest as their degree of impatience for present enjoyment is high. Further more if an individual is certain about the consumption of a commodity in the future his impatience for the present will be less i.e. the degree of time preference will be smaller.
(3) Interest is paid as a reward for parting with liquidity:-
According to Keynes interest is the payment for giving up liquid money (cash) from the possession of a man. According to Keynes people have preference for liquidity. Preference for liquidity means people have a demand for holding money or cash balances. In order to induce people to part with liquidity i.e. cash balances they must be paid a reward in form of interest. It is the preference of liquidity that the people want to have more and more money in form of cash. Thus liquidity preference constitutes demand for money.
People prefer to hold cash balance because of three motives. They are transaction motive, precautionary motive and speculative motive. People want to hold easy for transaction motive in the sense that they spend for their daily requirements of goods and services. Under precautionary motive people want to hold money to meet the unforeseen contingencies. Under speculative motive people demand money in order to take advantage of changes in rate of interest.
Considering the above theories about why interest is paid, it is concluded that some amount of sacrifices in terms of time, waiting and present consumption are involved in the process of lending business. To compensate these sacrifices people are induced by being paid interest.