Theory of Interest
for BBS Business Economics
By
Khemraj Subedi
Associate Professor
M.Phil in Economics
PhD Scholar in Economics
Tikapur Multiple Campus
Far Western University

Meaning of Interest
 Money that is paid in exchange for borrowing
or using another person's or organization's mon
ey is called interest.
 In simple meaning interest is a payment made
by a borrower to the lender for the money
borrowed and is expressed as a rate percent per
year.
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Gross Interest and Net Interest:
 Gross interest is the amount paid by a borrower to a
lender as a return on capital borrowed.
 When we talk about interest, it is gross interest.
 Gross interest not only includes payment for use of
funds but also the compensation for the risk
involved in recovering the loan, return for
inconveniences, cost of managing loan etc.
 Net interest is the price paid for the use of capital
only.
 It deducts all other payments paid other than use of
capital.
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Liquidity Preference Theory of Interest:
 Propounded by J.M. Keynes in 1936 AD.
 Published in his very well known book ‘The General
Theory.”
 Keynes, “Interest is a reward for parting with
liquidity for specified period.”
 Interest is purely monetary phenomenon and
determined by the interaction between demand and
supply of money.
 Liquidity preference means the demand for money
to hold or desire of public to hold cash. 4

 Demand for money is determined by the
liquidity preference of the consumers.
 Higher the liquidity preference higher the rate
of interest and vice versa.
 Liquidity preference also shows the demand of
money.
 Hence, liquidity preference curve also shows the
demand curve of money.
 Due to inverse relationship between rate of
interest and demand for money, demand curve of
money i.e. liquidity preference curve is negative
sloped. 5

Demand for Money:
 According to Keynes, there are three motives for
the demand for money or liquidity preference,
which are:
1. Transaction Motive:
 Demand of money for day to day transactions.
 Depends on the size of money income, Lt = f (Y)
2. Precautionary Motive:
 Desire to hold cash balance in order to meet certain
unforeseen contingencies and emergencies such as
sickness, accidents, unemployment etc.
 Also depends on the level of income, Lp = f (Y) 6

 Active Cash balance (L1) = Lt +Lp = f (Y)
3. Speculative Motive:
 Demand for holding cash to make speculative gains
out of the purchase and sale of bonds and securities
due to future changes in rate of interest.
 It is determined by rate of interest and bond prices.
 It is inverse function of interest rate.
 Speculative demand for money is also called as idle
cash balance.
 Idle cash balance = Lsp or L2 = f (r)
 Total demand for money (L) = L1 + L2
= (Lt +Lp) +Lsp
= f (Y) +f (r)
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Graphically,
O Demand for Money
Rateinterest
LP curve or
demand curve for money
A
B
C
Liquidity Trap
r1
r2
r3
M1
M2 M3
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Supply of Money:
 Central bank is responsible body for money
supply.
 Which controls and regulates supply of money.
 It refers to the total quantity of money in the
country for all the purposes at a particular point of
time.
 Supply of money remains constant is a point of
time and interest inelastic. So, supply curve is
parallel to Y-axis.
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Determination of Rate of Interest:
 Interest rate in liquidity preference theory is
determined by the interaction between total
demand for money and total supply of money.
 It means, when negatively sloped LP-curve i.e.
demand curve for money intersects vertical
supply curve of money, it determines equilibrium
rate of interest.
 The process of determining equilibrium rate of
interest in this theory can be explained
graphically as following. 10

O Demand and supply of Money
Rateinterest
r
LP-curve
S
M
S1 S2
E
E1
E2
M1 M2
r1
r2
Determination of rate of Interest
and
effect in rate of interest with Change in Supply of Money:
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Effect in rate of Interest with Change in
Liquidity Preference:
O Demand for Money
Rateinterest
r2
LP2
S
M
E2
LP3
LP1
r1
r3
E1
E3
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Thank You!
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