Individuals Businesses

Individuals Businesses

Individuals, businesses and public authorities create the demand for loanable funds because they want more money to spend than they derive from current income and because borrowed funds can be spent on investments which yield a rate of return higher than the cost of borrowing (the rate of interest). In general, the higher the expected return from new investment the larger the demand for loanable funds and, therefore, the more the willingness to pay a higher rate of interest. In Government investment projects, however, there is little opportunity of making precise calculations of the relationship between yield and cost because there is no free market in the goods (or services) produced, or in the factors of production (e.g. all miners are employed by the National Coal Board), or both. These projects are usually the result of political decisions connected with the desire to influence general economic activity, the provision of welfare services, the view that the so-called 'basic' industries should be owned and/or run by the state, etc.

The economic theory of the general level of interest rates uses a convenient abstraction the 'rate of interest' which usually refers to the yield on riskiness, fixed-interest securities, such as irredeemable Government bonds. Thus, a bond costing £100 and paying per annum yields 3 per cent interest; if the price of the bond falls to 160, rate money yield is still 3 but the te of interest is 5 per cent. What determines this rate of interest? An explanation of the rate of interest now widely held by many economists is Keynes's liquidity! preference theory. In brief, it holds that the rate of interest equates the demand for money to hold as an asset with the supply of money available to be held, so that it is determined by the community's liquidity preference and the quantity of money as decided by the monetary authorities. Changes in liquidity preference (the supply of money remaining unchanged) or changes in the quantity of money (liquidity preference remaining unchanged) will therefore change the rate of interest. Suppose the demand for money is equal to the supply and the Government, through open market operations, increases the quantity of money. Equilibrium has changed to dis-equilibrium. At the prevailing rate of interest the community is holding more asset money than it wishes. It increases its demand for income-yielding assets, such as bonds, causing their prices to rise and the rate of interest to fall. At the higher prices some owners become willing to sell bonds and to hold cash instead. In this way the surplus cash is finally absorbed by the sellers of securities, and the system is again in equilibrium, but with a lower rate of interest.

This is a monetary theory of interest. Some economists emphasize the 'real' forces governing the payment of interest. In a simple non-monetary economy the production of capital goods (investment) can take place only to the extent that the community is willing to forgo the use of resources employed to produce consumption goods. The interest offered for loans (expressed in terms of real resources) would be governed by the additional productivity of investment in methods of production that use more capita! (i.e. are more 'roundabout'). The interest demanded by lenders would thud to reflect their rate of 'time preference', the premium they place on enjoying consumption goods immediately rather than in the future. Together, time preference and productivity govern the supply and demand for loanable resources and thus the rate of interest.

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