Theory of Interest
A brief overview of modern interest
theories
Knut Wicksell (1851-1926)
 Born in Stockholm, Sweden, 1851
 Son of a successful businessman and
real estate broker
 Orphan at the age of 15
 Mathematics and Physics
 1887: Economics
 1898: Interest and Prices
 1916: Swedish government advisor on
financial and banking issues
 main intellectual rival was the American
economist Irving Fisher
Interest and Prices
natural rate of interest
real profit (r)
MPK
vs. money rate of interest
money market (i)
Cumulative Process model
MPK > i  I > S  M rises
Demand > Supply  prices rise
The demand for loans will continue accumulating, and the banking system's
deposit creation continues indefinitely - with savings never really catching
up. Money supply will expand endogenously without limit and prices will
also rise without end.
What can end this process?
Reserve Requirement Constraint
Irving Fisher (1867-1947)
Born in New York, 1867
 Yale University

• 1888: B.A.
• 1891: Ph.D.
Mathematics & Economics
 1930: The Theory of Interest

The Theory of Interest:
As determined by the
impatience to spend income
and
opportunity to invest it.



Income
Capital
Interest
Income

3 stages:
• Psychic income or enjoyment income
• Real income
• Money income or cost of living
real income
The Thames below Westminster
about 1871
Oil on canvas 47 x 72.5 cm.
Money Income
Capital
any asset that produces a flow of income over time


“The value of any property, or rights to wealth, is its value as a
source of income and is found by discounting that expected
income” (Fisher, 1930, p.14).
the value of capital is the present value of the flow
of (net) income that the asset generates
Capital goods
Income
Capital value
Income value
Rate of Interest

capital value X rate of interest = interest
IMPATIENCE
OPPORTUNITY
(a) the time preference people have for
consuming today versus
consumption at a later time, and
(b)the expectation that income saved
and invested today will yield
greater income tomorrow – capital
produced today will generate
greater future production than was
required to construct the capital
Difference between Classical
economists and Irving Fisher

According classical economists there are four
sources of income:
•
•
•
•

Rent
Wages
Profits
Interest
Fisher treated interest not as a separate entity of
income, but as sub-entity within each of the 3
sources of income
Other non-economic factors that
influence rate of interest:






Foresight - intelligence
Self-control – willingness
Habit
Life Expectancy
The love of one's children
Fashion
Fisher, Irving. The Nature of Capital and Income.
New York: The Macmillan Company, 1906.
Octavo, 1st edition in original green cloth. $1600.
Source: http://www.manhattanrarebooks.com/fisher.htm
John Maynard Keynes (1883-1946)
Born in Cambridge, 1883
 King's College, Cambridge

 Mathematics
in 1905
 Alfred Marshall and Arthur Pigou
1936: General Theory
 1942: was made a lord
 1944: Bretton Woods Conference
 April 21, 1946 passed away

General Theory
“Liquidity-preference”
Financial wealth
i
Illiquid assets
Liquid assets
Wealth is allocated between liquid and illiquid assets
“Thus the rate of interest at any time, being the reward for
parting with liquidity, is a measure of the unwillingness of
those who possess money to part with their liquid control
over it. The rate of interest is not the “price” which brings
into equilibrium the demand for resources to invest with
the readiness to abstain from present consumption. It is
the “price” which equilibrates the desire to hold wealth in
the form of cash with the available quantity of cash; —
which implies that if the rate of interest were lower, i.e. if
the reward for parting with cash were diminished, the
aggregate amount of cash which the public would wish to
hold would exceed the available supply, and that if the rate
of interest were raised, there would be a surplus of cash
which no one would be willing to hold.” (Keynes, 1936).
Money Demand Theory
People hold money for three reasons:
Transaction Motive
► Precaution Motive
► Speculation Motive
►
Uncertainty
Expectation
On expectation
►
If E(Δi) > 0  Md > 0
►
If E(Δi) < 0  Md < 0
Md (E(Δi))
Interest Rate is a function of money demand and money
supply; it is a monetary factor
i* = i (Md, Ms)
Sir John Hicks (1904 - 1989)
Sir John Hicks





Born in 1904 at Warwick, England
Mathematics
Clifton College (1917-22)
Balliol College, Oxford (1922-26)
1937: IS-LM model
IS-LM model
Based on John M. Keynes’s General Theory
 All equilibria in both commodity and money
markets



IS curve: Y = f(i)  equality of S and I
LM curve: i = f(Y)  equality of Ms and Md
In 1982 Hicks rejected this model because although it is a
very useful apparatus to understanding Keynes’ General
Theory but it lacks one very essential thing that Keynes
already knew:
Uncertainty