Theories of Interest

Theories of interest explain why interest exists and how the rate of interest is determined.

Theory	Main Idea	Key Point for Exam
1. Classical Theory of Interest	Interest is determined by demand for investment and supply of savings.	Saving + Investment
2. Loanable Funds Theory	Interest rate is determined by demand and supply of loanable funds.	Demand & Supply of Loanable Funds
3. Liquidity Preference Theory	People prefer holding money in liquid form; interest is the reward for giving up liquidity.	Keynes
4. Time Preference Theory	People generally prefer present consumption over future consumption. Interest compensates for postponing consumption.	Present vs Future Consumption
5. Productivity Theory	Interest is the reward for using capital because capital contributes to production.	Productivity of Capital

1. Classical Theory

According to the classical economists, the rate of interest is determined by the interaction of savings and investment.

• Supply of savings → people willing to save
• Demand for investment → businesses requiring funds
• Equilibrium between the two determines the interest rate.

Exam keyword: Savings + Investment

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2. Loanable Funds Theory

This is particularly important from a banking perspective.

The interest rate is determined by the demand and supply of loanable funds.

Supply of loanable funds can come from:

• Savings
• Bank credit
• Disinvestment
• Dishoarding

Demand for loanable funds can come from:

• Investment
• Consumption
• Hoarding

Exam keyword: Demand and Supply of Loanable Funds

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3. Liquidity Preference Theory — J.M. Keynes

This is a very important JAIIB theory.

According to Keynes, people prefer to hold money because of three motives:

1. Transaction motive – money required for day-to-day transactions.
2. Precautionary motive – money kept for unforeseen expenses.
3. Speculative motive – money held to take advantage of future changes in interest rates/security prices.

Therefore:

Interest is the reward for parting with liquidity.

Exam keyword: Liquidity Preference → Keynes

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4. Time Preference Theory

People generally prefer to consume ₹1 today rather than ₹1 in the future.

Therefore, someone who postpones consumption expects compensation in the form of interest.

Example:

If you have a choice between:

• ₹10,000 today
• ₹10,000 after 1 year

You generally prefer ₹10,000 today.

But if someone offers ₹11,000 after one year, you may be willing to wait.

That additional ₹1,000 represents compensation for waiting.

Exam keyword: Present consumption vs Future consumption

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5. Productivity Theory

Capital is productive—it can be used to generate additional income/output.

For example, a bank lends ₹10 lakh to a business. The business uses the money to generate additional profits. The interest paid to the lender is partly explained as a return associated with the productive use of capital.

Exam keyword: Productivity of Capital

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JAIIB Quick Revision

Remember this table:

Theory	Remember
Classical	Saving + Investment
Loanable Funds	Demand + Supply of Funds
Liquidity Preference	Keynes + Liquidity
Time Preference	Present > Future
Productivity	Capital generates output

Likely MCQs

Q1. Who is associated with the Liquidity Preference Theory of Interest?
✅ J.M. Keynes

Q2. According to Keynes, interest is the reward for:
✅ Parting with liquidity

Q3. Classical theory determines interest primarily through:
✅ Savings and Investment

Q4. Loanable Funds Theory is based on:
✅ Demand and supply of loanable funds

Q5. Time Preference Theory is based on the preference for:
✅ Present consumption over future consumption

Q6. Which theory emphasizes the productive nature of capital?
✅ Productivity Theory

Most important for JAIIB: Focus especially on Liquidity Preference Theory, Loanable Funds Theory and