DEPARTMENT OF TECHNICAL EDUCATION

ANDHRA PRADESH

Name : G. M. Lakshmi
Designation : Lecturer
Institution : GPW Suryapet
Branch : DCCP
Year/Semester : VI th semester
Subject : Business Economics II
Subject Code : CCP-602
Main topic : Theories of Distribution
Sub-topic : Theories of Interest
Duration : 50 minutes
Teaching Aids : PPT, Animation
CCP602.15 1
 Objectives

On the Completion of this period , you would be

able to know:

• Theories of Interest
• Classical Theory of Interest

CCP602.15 2
 Recap

We have learned in previous class

• Meaning of Interest
• Gross Interest and Net Interest

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 Theories of Interest
1. Early classical ideas on interest can be grouped into
following set of theories

• Productivity Theory
• Abstinence Theory
• Time Preference Theory

2. Classical Theory of Interest

3. Loanable Fund Theory of Interest – Neo Classical

Theory of Interest

4. Keynes Liquidity Preference Theory of Interest

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 Classical Theory of Interest
• Interest is the reward for productive use of capital

• It is equal to the marginal productivity of physical

capital

• Rate of interest is determined by the intersection of

demand for and supply of capital

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 Contd…

• Investment decision of the entrepreneur determines

the demand for capital

• Investment demand schedule reflects the demand

for capital

• Supply of capital results from saving in the

community

• Savings schedule represents the supply of capital

CCP602.15 6
 Contd…
• It should be noted that the theory assumes real
savings and real investment

• Real savings is that part of the income which is left

unconsumed for investment purposes

• Real investment implies investment in capital goods

industries in real term

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Demand for Capital
• It comes from entrepreneurs who wish to invest in
capital goods industries

• Demand for capital implies demand for savings

• Capital is demanded because it is productive i.e

it has the power to yield an income even after
covering its costs i.e interests

CCP602.15 8
 Contd….
• Thus marginal productivity of capital determines the
demand curve for capital

• Investment demand expands when the rate of

interest falls

• Investment demand contract when the rate of interest

rises

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 Contd….
• The following figure illustrates investment demand schedule
Y

INVESTMENT FUNCTION
RATE OF INTEREST

R1
I
R2

O
Q1 Q2 X

INVESTMENT
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 Contd…
It can be seen that when the rate of interest is OR1, the
investment volume is OQ1 when the rate of interest falls
its OR2, investment volume rises to OQ2

Thus investment demand curve is a downward

sloping curve

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 Contd….
• The following figure illustrates Saving schedule
Y
RATE OF INTEREST

SAVING FUNCTION

R2

R1
S

O
Q1 Q2 X

SAVING
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 Contd…

In the above figure saving curve shows quantity of

savings at alternative rates of interest, when the rate of
interest is OR1 , OQ1 is the amount of savings, when
the rate of interest rises to OR2, savings expands to
OQ2. Thus the supply function or the supply of savings
curve is an upward sloping curve

CCP602.15 13
 Contd…

Rate of interest is determined at the point at which both

demand for and supply of capital are equal

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 Contd…
The following figure illustrates
Y
S
RATE OF INTEREST

R
I I

O
Q X
SAVINGS AND INVESTMENT

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 Contd…
• In the above figure O R is the equilibrium rate of
interest. It is determined at the point where supply of
savings curve intersects the investment demand curve

• Thus at the equilibrium rate of interest(O R) demand

for capital (OQ) is equal to supply of capital(OQ)

• According to classical theory the real factors like

savings and productivity in the economy determines
the rate of interest

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Summary

We have learned in the session

 The theories of interest

 Classical Theory of interest. Interest is determined

by demand for capital for investment purpose &
supply of capital i.e savings

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Quiz
Demand for capital
1. Interest is determined by __________________

Supply of capital
and _____________________

2. Classical economists measured interests in

_______________ terms
Real

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 Frequently Asked Questions
• List the theories of interests

• Explain the classical theory of interest

CCP602.15 19