The Theory of Interest rate and Profit sharing_Money and Banking
Liquidity Preference
Theory:
According to liquidity preference theory lender lends money
to borrow for the interest, and the interest is assumed to be a reward for
parting with liquidity. On the other hand, if a person does not an important
part with his savings, but uses them in his own productive activity, interest
will arise. However, Keynesian theory is advanced to the classical theory of
interest as the former is concerned with equilibrium points in the real economy
sector. Thus, in the real world, the Keynesian theory is more realistic than
the classical theory of interest than others.
Productivity
Theory:
Productivity theory of interest is a reward for the profitable
services in the capital of the production purpose. For example, a farmer having
tractor to plow the field produces more as compared to the farmer who does not
have it. Hence, interest is the payment for the productivity of capital.
The theory is criticized on the
following:
- The theory only focuses on the
causes for what the interest is paid but not on the determination of
interest rates.
- It emphasizes on the demand of
interest, but ignores the supply side of capital.
- It completely ignores how the
interest is paid for the loan borrowed for consumption purposes.
Abstinence or Waiting
Theory:
In the abstinence theory, interest is a reward for
abstinence. During, people less consumes and save more income, and they lend
this saving amount to others that is sacrifice of current consumption. Senior
the expert advocated that abstaining from consumption is unpleasant. Abstinence
theory was also criticized by some of the economists. According to the theory,
an individual can feel unhappy if they save as it reduces consumption. However,
rich people do not feel unpleasant while saving because they are financially
capable to meet their requirements.
Austrian or Agio
Theory:
Austrian theory is also called as a psychological theory of
interest. John Rae and Bohm Bawerk in an Austrian school advocated this theory. Therefore, future
satisfaction has a kind of discount if compared with present satisfaction. The
interest is the discounted amount that is required to be paid for inspiring
people to invest or transfer their present requirements to the future.
However, the theory has been
criticized by various economists:
- It arranges too much importance on
the supply aspect and ignores the demand aspect
- It does not focus on the
determination of rate of interest
Classical or Real Theory:
Classical theory is one of the most realistic in the economic
development, it helps to measure rate of interest with the help of demand and supply
factors. Demand refers to the demand of investment and supply refers to the
supply of savings. According to this theory, the rate of interest refers to the
amount paid for saving. Therefore, the rate of interest can be determined with
the help of demand of saving needed to invest in the capital goods and the
supply of savings.
