Introduction

 A financial system is a set of institutions such as banks,

that permit the exchange of funds
 Borrowers, lenders, and investors exchange funds to
finance projects, either for consumption or productive
investments, and to pursue a return on their financial
assets
 The financial system also includes sets of rules and
practices that borrowers and lenders use to decide
which projects get financed, who finances projects, and
terms of financial deals
 They operate at national and global levels
 Financial systems can be organized using market
2 principles, central planning, or a hybrid of both
 ……Continued
 Financial system consists of financial markets and
financial institutions
 Financial market: is an institutional arrangement in which
long term and short term financial assets are transacted
between buyers (savers) and sellers (borrowers)
Financial institutions: are the rulers of the game which
facilitate the flow of funds from savers (lenders) to
borrowers in the most efficient manner
 They guide purchasing power from surplus spending
units (savers) to deficit spending units (borrowers)
 Households, state and local governments, federal
governments and a large number of business firms can
3
all be either savers or borrowers
 ……Continued
 There are three types of financial institutions; Formal (like
banks), Informal (like equb) and Semi-formal financial
institutions (like Saving and credit cooperatives (SACCOS)
Formal and semi-formal financial institutions in financial
markets can be further divided into two:
(I) Depository Institutions: are financial institutions which
keep deposits from savers
 By collecting deposits from depositors, depository
institutions use these funds for advancing loan or purchase
other debt instruments such as treasury bills
 Depository institutions include:
i. Commercial Banks: are the largest and most important
depository institutions which keep deposits of individuals and
firms in various types of accounts in the form of cash and
4
assets and use them for advancing loans
 ……Continued
ii. Saving and Loan/Credit Associations: are operated by
individuals by collecting their savings in a mutual
association
 They convert their saving funds into mortgage loans
iii. Mutual Saving Bank: they operate like saving and
loan associations
 The only difference is that the latter is established on
the basis of co-operation by employees of some
company, a trade union or other particular institution
iv. Cooperative Saving and Credit Society: the members of
saving and credit cooperative societies purchase some
share of the cooperative societies, deposit their saving
with
5
them and borrow from them
 ……Continued
(II) Non-depository Institutions:
 Non-depository intermediaries don't take deposits
 They operate in the financial market as financial
intermediaries and provide insurance against financial
risks
 Non-depository financial institutions include:
i. Insurance Companies:
 Insurance is defined as a contract, which is called a policy,
in which an individual or organization receives financial
protection and reimbursement/compensation of damages
from the insurer or the insurance company
 At a very basic level, it is some form of protection from any
possible financial loss
 Insurance companies sell protection against losses incurred
by illness, disability, death, and property damages such as
6
automobile accidents or fires
 ……Continued
 They spread the loss that a person may face due to a
particular risk over several persons, who are exposed
to it and who agree to insure themselves against the
risk
 To finance claims payments, they collect premiums
from policyholders, which they invest in stocks, bonds,
and other assets
 They also use a portion of their funds to make loans to
individuals, businesses, and government agencies
 They invest it in short-term assets
ii. Mutual funds: are pools of money, also known as units,
collected from many investors for the purpose of
investing
7
in stocks, bonds, or other securities
 ……Continued
 Mutual funds are owned by a group of investors and
managed by professionals
 In other words, a mutual fund is a collection of securities
owned by a group of investors and managed by a fund
manager
 Mutual fund companies sell their shares to other
individuals and firms and invest it in other types of short
term and/or long term (capital) assets
 Accordingly, some mutual funds, known as money market
mutual funds, invest in short term assets such as treasury
bills, certificate of deposit of banks etc
 This type of mutual fund focuses on getting returns coming
into the fund primarily through interest
 Equity funds, on the other hand, invest in long term assets
such as stocks
8
 ……Continued
iii. Investment Trusts: are companies whose shares can be
bought on the stock exchange and whose business is to
make money by buying and selling stocks and shares
 It differs from mutual funds, which issue units
representing the diversified holdings rather than
shares in the company itself
 Investment trusts are 'closed-ended' investments,
meaning they issue fixed number of shares when
they're set up, which investors can buy and sell in the
stock market
 This means investment trust managers always have a
fixed amount of money at their disposal, and won't
have to buy and sell to meet consumer demand for
shares
9
 ……Continued
 This can add a degree of stability to investment trust
management that a unit trust manager won't have
 Mutual funds, on the other hand, are 'open-ended'
investments and can issue or redeem units at any time
to satisfy investors who want to buy into the fund or
sell their stake
 This may cause problems, as the managers may have
to sell assets at a low point to pay investors who want
to sell units
iv. Trust Companies/Pension Funds: administer pension
or retirement funds, and they also perform financial
services
10
 ……Continued
 For many people, saving for retirement is the most
important form of saving
 These companies take contributions from people and
promise in return to provide future income
 Pension funds invest contributions from
workers/employees and firms/employers in stocks,
bonds, and mortgages to earn the money necessary to
pay pension payments when contributors retire
 Growth for the contributor comes not from interest on
deposits, but investments made by the administrator of
these pension funds

11
 ……Continued
iv. Brokerage Firms:
 A brokerage firm, or simply brokerage, is a financial
institution that facilitates the buying and selling of
financial securities between a buyer and a seller
 Brokers are people who execute orders to buy and sell
stocks and other securities
 They are paid commissions
 They provide service to help investors do as well as
possible with their investments
 Brokerages may offer advice or guidance to individual
investors as well as pension fund managers and
portfolio managers alike
 They are private companies who make a profit on the
12
transactions
 2.1. Functions and structures of Financial Markets
 Financial market, simply put, is a platform that facilitates
traders to buy and sell financial assets
 These assets can be shares, stocks, bonds, bills, debentures,
checks, foreign exchanges, precious metals, and more
 They play a vital role in facilitating the smooth operation of
capitalist economies by allocating resources and creating
liquidity for businesses and entrepreneurs
Functions of Financial Markets
 Price Determination: demand and supply of an asset
(financial instrument) in a financial market help to
determine their price
 Savers/Investors (those who make financial investments)
are the suppliers of the funds, while businesses or other
investors (those who are in need of those funds) borrow
money are on the demand side of the financial market
13
 …...Continued
 Thus, the interaction between these two participants
and other market forces help to determine the price
 Mobilization of savings: for an economy to be efficient,
it is crucial that the money does not sit idle
 Thus, a financial market helps in connecting those with
money with those who require money
 Ensures liquidity: assets that buyers and sellers trade in
the financial market have high liquidity
 It means that investors can easily sell those assets and
convert them into cash whenever they want
 Liquidity is an important reason for investors to
participate in trade
14
 …...Continued
 Risk sharing: financial markets perform the function of the
risk-sharing as the people who are undertaking the
investments (borrowers) are different from the people who
are investing their fund in those investments (savers)
 With the help of financial markets, the risk is transferred
from the person who undertakes the investments to the
person who provides the funds for making those
investments
 Saves time and money: the industries require the investors
for raising the funds, and the investors require the
industries for investing their money and earning the
returns from them
 Financial markets serve as a platform where buyers and
sellers can easily find each other without making too much
efforts or wasting time
15
 ……Continued
 Capital Formation: financial markets provide the
channel through which the new savings of the investors
flow in the country which aid in the capital formation
of the country
 Also, since these markets handle so many transactions,
it helps them to achieve economies of scale
 This results in lower transaction cost and fees for both
sides (the investors and entrepreneurs alike)
Classification/Types of the Financial Markets
 Financial market is such a broad term that just
mentioning their types will not give learners a good
idea of the financial markets
 That is why we are going to classify them under two
different categories
16
 …...Continued
Based on the Nature of the Claim/Asset
1. Equity Market: the equity market, or the stock market,
is the arena in which stocks are bought and sold
 This is the market where shares of the company are
listed and traded after their IPO
 An initial public offering (IPO) refers to the process of
offering shares of a private corporation to the public in
a new stock issuance
 It is a market where investors deal in stocks or other
equity instruments
 Equity, or stock, represents a share of ownership of a
company
 The owner of an equity stake may profit from
dividends
17
 …...Continued
2. Debt Market: the debt market, or bond market, is the
arena in which investment in loans are bought and sold
 This market allows companies and the government to
raise money for a project or investment
 In the debt market, investors buy and sell fixed claims
or debt instruments, like bonds from other companies
which later return the amount with agreed interest
 Transactions in debt markets are mostly made between
large institutions including the government or by
individual investors
 Investments in debt securities typically involve less risk
than equity investments, but offer a lower potential
return on investment than investments in stocks
18
 ……Continued
3. Commodities market: in this market, investors buy and
sell natural resources or commodities, like oil and gold
Based on the Maturity of Claim
1. Money Market: it is the trade in short-term debt
 It is a constant flow of cash between governments,
corporations, banks and other financial institutions by
borrowing and lending financial assets for a term as
short as overnight and no longer than a year
 Assets that investors buy and sell in this market are
promissory notes, bill of exchange, certificate of
deposit, short term government securities, treasury
bills, and more
19
 ……Continued
 It is the market for short term instruments that are
close substitutes for money
 These short term instruments are highly liquid, and
easily marketable with little chance of loss
 It meets the short term requirements of borrowers and
provide liquidity or cash to the lenders
 They are used for financing current business
operations, short term need of the government, and the
need of the consumers
Functions of the money market
It provides short term funds to both public and private
institutions
It provides opportunities to banks & other institutions
20
to use their surplus funds profitably for a short period
 ……Continued
It removes the necessity of borrowing by the
commercial banks from the central bank
It helps the government in borrowing short term funds
at a lower interest rate by issuing treasury bills
It helps to make financial mobilization
It promotes liquidity and safety which encourage
investment and saving
It helps to bring equilibrium between money supply
and money demand of loanable funds
Economizing the use of cash since these assets can be
used as money; because they are near money assets
 The main players (institutions) in money market
include: the central bank, commercial banks, NBFIs,
21
short-term bill/security markets, and more
 ……Continued
2. Capital Market: it encompasses the trade in both
stocks and bonds
 It is in capital markets where investors buy and sell
medium and long term financial assets
 There are two types of capital market:
 Primary Market (where a company issues its shares for
the first time (IPO), or already listed company issues
fresh shares) and
 Secondary Market or Stock Market (where buyers and
sellers trade already issued securities in the primary
market)
Functions of capital market
It acts as an important link between savers and
investors
22
 ……Continued
 It gives incentives to savers (higher returns) and investors
(capital formation)
 It creates stability in the value of stock and security by
providing capital at reasonable interest rates and helps in
minimizing speculative activity
 It promotes employment, economic growth and wealth
since they convert financial assets into physical assets
 It provides a revenue for channeling the saving for
productive economic activities
 The main players (institutions) in the capital market
include: the stock markets, mutual funds, insurance
companies, investment trusts, development banks, and
more
 Together, the money market and the capital market
comprise a large portion of the financial market
23
 2.2. Financial Instruments
 Financial instruments are assets or packages of capital
that may be traded in the financial market
 It is a real or virtual document representing a legal
agreement involving any kind of monetary value
 The document represents an asset to one party and
liability to another
 It can be a contract between parties; like bond, share,
bill of exchange, check, draft, and more
 Financial instruments carry a monetary value and are
legally enforceable
 One can also create, modify and trade such
instruments, which represent a binding agreement
24 between two or more parties
 Types of Financial Instruments
 Many instruments are custom agreements that the parties
mold to their own needs
 However, many financial instruments are based on
standardized contracts with predetermined characteristics
 Financial instruments can be broadly classified into money
market and capital market instruments
Money market instruments are securities that provide
businesses, banks, and the government with large amounts of
low-cost capital for a short term
 Many of these instruments are part of the money supply in
economies with highly developed financial markets
 They include the following:
 Treasury Bills: governments raise cash by issuing treasury
bills
 Treasury bills are sold at a discount to their face value, and
the difference between the discounted purchase price and
25 face value represents the interest rate
 ……Continued
 Certificate of Deposit (CD): is issued directly by a
commercial bank from a depositor, but it can be
purchased through brokerage firms
 CDs can range from Short to medium term deposits
with a financial institution that draws interest
 Most CDs offer a fixed maturity date and interest rate,
and they attract a penalty for withdrawing prior to the
time of maturity
 Commercial paper: is an unsecured loan issued by large
institutions or corporations to finance short-term cash
flow needs, such as inventory and accounts payables
 It is issued at a discount, with the difference between
the price and face value being the profit to the investor
26
 ……Continued
 Inter-bank term market: is exclusively for commercial
banks and other cooperative banks which borrow and
lend funds usually for up to 90 days without any
collateral at market interest rate
 Bill of exchange: is a written order requiring a person
to make a specified payment to a named payee
 It arises from a genuine trade transaction
 The seller, after selling his good, receives a bill from the
buyer who agrees to pay the specified amount either on
demand or after a specified period generally not
exceeding 3 months
 When the buyer signs the document signifying
acceptance, it becomes a commercial paper called a bill
of exchange
27
 ……Continued
 Capital market instruments are instruments that use
medium and long term securities
 They are mainly of two types:
 Bond: is a basic debt security that is traded in the
capital market
 Both governments and companies issue different types
of bonds to raise capital from investors
 Issuing bonds helps companies to raise capital for long
term growth and expansion of their businesses at
cheaper interest rates than banks and other lending
institutions
 The government also issues bonds to finance public
projects
 The bond issuer (government or business) pays interest
28 and returns the principal at the end of the duration
 ……Continued
 Stock: is the right of ownership in a company
 The buyer of stocks (shares) is known as shareholder
 These shares are the prime source of finance for a
public limited company
 When individuals and institutions purchase them, they
become shareholders & have the right to vote and also
benefit from dividends when the company makes profit
 Shareholders are, therefore, the co-owners of the
company since they hold the company’s shares
 However, the dividend which shareholders receive is
dependent on the company's profitability and the
management’s decisions
29
 2.3. Financial intermediaries
 Financial intermediaries are institutions that efficiently
intermediate in the financial process between
borrowers and lenders/investors in the economy, to
meet the financial objectives of both parties
 How do they act as a link between savers & borrowers?
 Suppose Mr. X is a government worker and deposits
his savings into his account with bank A every month
 On the other hand, Mr. Y is a young entrepreneur who
is seeking a loan to start his venture
 Now, Mr. Y has two options for availing the loan:
 The first option is that he can find and convince the
individuals who are looking for investment
opportunities to lend him, or
 He can approach bank A for a loan
30
 ……Continued
 We can see that the first option is uncertain, and it will take
a lot of time to find the investors
 However, the second option is more convenient, quick and
efficient
 Thus, we can say that financial intermediaries facilitate an
efficient way of lending and borrowing of funds on a large
scale
Types of Financial Intermediaries
 Go back to the first few slides of this chapter
 Further classification of financial intermediaries varies
from country to country, and changes over time depending
on the nature of financial intermediaries operating at a
given time and place, which in turn is greatly influenced by
prevailing legal arrangements and financial custom
Functions of Financial Intermediaries
31
 Go back to 2.1. section of this chapter
 2.4. Interest rates and their measurement
 In common understanding, interest rate is a payment made
by the borrower to the lender of money
 It is the amount a lender charges for the use of a money
loan expressed as a percentage of the principal
 In real economic sense, interest is the return for capital as a
factor of production
 It applies to most lending or borrowing transactions
 Individuals borrow money to purchase homes, fund
projects, launch or fund businesses, etc
 Businesses take loans to fund capital projects and expand
their operations by purchasing fixed and long-term assets
such as land, buildings, and machinery
 The government takes money loans to finance its budget
32 deficits of both capital and current expenditures
 ……Continued
 Interest can be either simple or compounded
 Simple interest is based on the principal amount of a loan
or deposit
 In contrast, compound interest is based on the principal
amount and the interest that accumulates on the principal
in every period
 The fact that simple interest is calculated only on the
principal amount means it is easier to determine than
compound interest
 Interest rates are typically noted on an annual basis,
known as the annual percentage rate (APR)
 The formula for calculating simple interest is:
Simple Interest (Is) = P*r*n
 Where: P = Principal amount; r = Annual percentage or
interest rate; n = Term of loan, in years
33
 ……Continued
 The formula for calculating compound interest is:

 Where: P = Principal amount; r = Annual interest rate;

k = the number of compounding periods in one year; &
n = Term of loan, in years
 If the compounding is done annually, k = 1
 If the compounding is done quarterly, k = 4
 If the compounding is done monthly, k = 12

 When calculating compound interest, the number of

compounding periods makes a significant difference
 Generally, the higher the number of compounding
34 periods, the greater the amount of compound interest
 ……Continued
 Example: Suppose that you deposited 20,000 birr in one of
the commercial banks which pays 4% annual interest rate.
How much will your interest be after 18 years: (a) if the
bank pays simple interest? (b) if the bank pays compound
interest, compounded quarterly?
(a) Is = P*r*n = 20,000*0.04*18 = 14,400
 So after 18 years, you will have 34,400 birr, which is the
principal plus the interest (20,000+14,400)
 
(b) Ic  P (1  k )  1  20,0001  4   20,000
r kn 0.04 72

Ic  20,0001.01  20,000  20,0002.047   20,000

72

Ic  20,940
 So after 18 years, you will have 40,940 birr, which is the
35 principal plus the interest (20,000+20,940)
 ……Continued
 Exercise: Suppose Mr. Abebe will need 50,000 birr at
the end of his 10 year planning period to invest that
money in the financial market. He has unspecified
amount of money deposited in Abyssinia Bank. How
much should that deposit be today to get his planned
50,000 birr after 10 years: (A) if Abyssinia Bank pays a
simple annual interest of 10%? And (B) if the bank pays
10% annual interest, compounded monthly?
(A) 50,000 = P + Is; where P = principal & Is = P*r*n
50,000 = P + (P*0.1*10) = P (1+ 1)  50,000 = 2P
P = 25,000
 So, Mr. Abebe should have 25,000 birr deposit now at
Abyssinia Bank to get his 50,000 investment plan after
36
10 years if the bank pays simple interest rate
 ……Continued
(B) 50,000 = P + Ic
 where P = principal & Ic  P(1  kr ) kn  1
50,000  P  P (1  12 )  P  P1  0.0083
0.1 120 120

50,000  P1.0083  50,000  2.6963P

120

P  18,544
 Mr. Abebe’s deposit should be 18,544 birr now at
Abyssinia Bank to meet his 50,000 investment plan after 10
years if the bank pays compound interest rate
Nominal and Real Interest rates
 Interest rates can also be nominal or real
 Nominal Interest Rate: is the stated interest rate (interest at
its face value) of a loan, which signifies the actual
37 monetary price borrowers pay lenders to use their money
 ……Continued
 Simple or compound, all those rates at their face values
are what we call nominal interest rates
 If you borrow 1,000 birr at a 10% interest rate, you
can expect to pay 100 birr in interest after a year
without taking inflation into account
 Real Interest Rate: is the nominal interest rate adjusted
for inflation
 It gives investors a more accurate measure of their
buying power, after they redeem their positions
 This is the effective interest rate that you earn or pay
 The nominal interest you collect from your deposits
won’t necessarily enable you to buy more stuff with
your money after the given period of time
 If you deposit 1,000 birr at a nominal rate of 10%, you
38 expect to get 1,100 birr after a year
 ……Continued
 However, when there is inflation, the purchasing power
of the interest you earn diminishes
 Your real interest is the nominal interest rate (the
interest you get paid) minus the rate of inflation (the
loss of purchasing power)
 If you get 10% nominal interest rate, but the inflation
rate is 6% during that same time; then the real rate of
interest is actually only 4%
 The real interest rate gives lenders and borrowers an
idea of the real rate they receive after factoring in
inflation
 This also gives them a better idea of the rate at which
their purchasing power increases or decreases
39
 Theories of Interest Rate
 Different theories have been put forward regarding
why interest is paid and how it is determined
1. Productivity Theory of Interest
 It is probably the oldest theory of interest which claims
that interest is paid for the productivity of capital
 In other words, according to this theory, interest arises
on account of the productivity of capital
 The amount that labor produces with the help of
capital goods is generally larger than the amount it can
produce when working by itself
 That is to say, a fisherman with a net can catch more
fish than without it, or agricultural labor with tractor
can produce more than without a tractor
 This theory simply states that the marginal
40
productivity of capital determines the rate of interest
 ……Continued
 Accordingly, the higher productivity of capital makes the
interest higher, and vise versa
 So, a producer would employ capital up to that amount at
which the rate of interest becomes equal to the value of the
marginal product of capital
 Criticisms of the Theory
1. Economists criticize this theory for being one-sided and
having ignored the scarcity and supply of capital that
determine the rate of interest
 In that sense, it is half-truth, because it is related only to
the demand aspect of capital and it completely ignores the
supply side
 If the supply of capital is abundant, then, however great
the capital productivity may be, the question of interest will
41
not arise, or at least, Interest will only be normal
 ……Continued
 Hence, in effect, it is scarcity (supply) rather than
productivity which explains interest
2. If interest depends merely on productivity, interest
rates should vary in proportion to the productiveness of
capital
 Actually, in spite of the productivity of capital, rate of
interest tends to be the same in the market
3. It is difficult to measure the exact productivity of
capital, as capital cannot produce anything without the
help of labor and other factors
 Like the marginal product of other factors, the
marginal product of capital cannot be separately
determined as every product is jointly produced by all
the factors
42
 ……Continued
2. Abstinence or Waiting Theory of Interest
 Abstinence theory explains interest from the supply
side whereas the productivity theory explains it from
the demand side
 This theory holds the view that interest is the reward
for the abstinence from the present consumption
 People save to create capital goods, but saving implies
the abstinence from, or the sacrifice of, present
consumption
 People may spend all of their income in consuming
present goods
 But when they save, they ‘abstain’ from present
consumption
 The abstinence is, however, unpleasant & most people
43
do not like it
 ……Continued
 So interest must be paid to induce people for making
the sacrifice of the present consumption
 Interest is, therefore, the compensation for abstinence
 Criticisms of the Theory
1. This theory has failed to explain the demand for
capital, hence it is one-sided theory
 In fact, the borrower uses and pays for the capital
because it is productive
2. This theory is also criticized on the ground that
abstinence does not always involve suffering
 Rich people save without least inconvenience, and they
do not undergo discomfort or suffering on account of
44 saving
 ……Continued
3. The Austrian or Agio Theory of Interest
 This theory seeks to explain Interest on the basis of time-
preference
 Interest is the price of time or reward for agio, i.e., time
preference
 According to this theory, interest arises because people
prefer present goods to future goods
 They prefer present to future because future satisfaction,
when viewed from the present, undergoes a discount
 Interest is this discount, which must be paid in order to
induce people to lend money and thereby to postpone
present consumption to a future one
 So, interest is nothing but an agio or premium or price that
must be given to people to induce them to save and
accumulate capital
45
 ……Continued
 Criticisms of the Theory
1. Failure to explain the forces of demand and supply of
capital that determine the rate of interest
 As a matter of fact, the theory does not throw light as
to how the rate of interest is determined
2. It is also pointed out that interest is not paid merely
because the tender must be induced
 The interest is paid because the borrowers are willing
and able to pay the loan depending on productivity
4. Fisher’s Time Preference Theory of Interest
 Prof. Fisher’s Time Preference Theory is the modified
version of the Agio theory in a sense that it also
46 emphasizes time preference as the central point
 ……Continued
 According to this theory, interest is the price of time
 In the words of Fisher, “interest is an index of community’s
preference for a dollar of present over a dollar of future
income”
 People, in general, prefer the present to the future and this
is what he calls the time preference
 People normally put a lower valuation on future goods
than on present goods
 Because of their time preference, people are eager to spend
their income on present consumption
 Therefore, when somebody lends to someone, he has to
forgo his present consumption
 He can be made prepared to leave his present consumption
47 only when he is offered some sort of reward
 ……Continued
 Interest is the reward or the price paid to the people
for present income rather than for future income
 According to Fisher, the rate of interest varies
according to the savers’ time preference
 The time preference, in turn, depends upon the size of
income, the distribution of income over the period of
time, the composition of income (i.e. permanent and
temporary), the character of the individuals and
expectation of the life of the people
 If, for instance, the income of an individual is large, the
individual will satisfy present wants more with a lower
discount for the future
 Regarding the distribution of income, we can have
three scenarios
48
 ……Continued
 If the income is uniform throughout life, people will
have their time preference according to the size of their
income and temperament
 If the income increases with age, people will tend to
discount the future at a higher rate because their
future is well provided
 If the income decreases with age, the future will be
discounted at a lower rate
 Criticisms of this Theory
1. This theory is criticized as one-sided as it only explains
why capital has a supply price (as the outcome of savings
alone), but fails to explain why capital has a demand
 In other words, it completely ignores the productivity
aspect of capital
49
 ……Continued
2. It is incorrect to say that a person always prefers
present consumption to the future one so that he always
insist on a premium to be paid for postponement
 On the contrary, strangely enough, very often people
are found to have realized greater satisfaction from
future consumption than the present one
5. The Classical Theory of Interest
 According to this theory, rate of interest is determined
by the demand for and supply of capital
 The demand for capital is governed by its (expected)
marginal productivity as is the supply of capital by
waiting or saving (time preference)
 That is why it is also referred to as Demand and Supply
Theory of waiting or saving
50
 Let us see demand and supply of capital separately
 ……Continued
 Demand for Capital
 Demand for capital arises on account of its productivity
 Investors agree to pay interest on these savings; because
the capital projects, which will be undertaken with the use
of these funds, will be so productive that the returns on
investment realized will be in excess of the cost of
borrowing, i.e., Interest
 The marginal revenue productivity curve of capital thus
determines the demand curve for capital
 Marginal revenue productivity of capital = the marginal
physical product of capital * the price of the product
 The investor will be induced to invest more till marginal
revenue productivity of capital is equal to the rate of
51 Interest
 ……Continued
 Thus, the investment demand expands when the
Interest rate falls and it contracts when the Interest
rate rises
 As such, the demand for capital is regarded as the
inverse function of the rate of Interest
 Supply of Capital
 The supply of capital depends upon the people’s will
and power to save considering their time preference,
income level, their temperament, etc.
 Some people save irrespective of the rate of interest
 They would save even if the rate of interest is zero
 Others save just because the current rate of interest is
52 enough to induce them to save
 ……Continued
 Equilibrium Rate of Interest
 The rate of interest comes to the equilibrium position
at the level where the demand for capital becomes
equal to its supply
Rate of Interest (R)
DD (Investment) SS (Savings)

Re

O Ce Capital (C)
53 Savings and Investment
 ……Continued
 In the figure given above, Re is the equilibrium rate of
Interest which is determined by the intersection of demand
and supply of capital (i.e. savings and investment), and Ce
is quantity of capital supplied as well as demanded
 Criticisms of the Theory
1. This theory is criticized on the ground that it assumes the
existence of full employment
 Full employment does not usually prevail, and in less than
full employment situation, people need not be paid for
abstaining from consumption (i.e., for saving)
2. This theory assumes that saving and investment are
interest elastic, i.e., they are sensitive to changes in the rate of
interest
 In reality, however, investment depends more on marginal
efficiency of capital and future expectations than on the
54 rate of interest
 ……Continued
 Similarly, savings are rarely interest elastic
 People may save without any rise in the rate of interest,
or may save even if the rate of interest falls to zero
 In fact, savings are more influenced by the level of
income than by the rate of interest
3. Rate of Interest is not an equilibrating force
 According to the classical economists, the equality
between saving and investment is maintained by the
interest rate adjustment mechanism
 Keynes objected to this view and gave a different
mechanism for restoring the equality
 According to him, income, and not rate of interest, is
55 the equilibrating force between saving and investment
 ……Continued
 Whenever saving exceeds investment, income level
declines, saving falls and becomes equal to investment
 Similarly, if investment exceeds saving, income level
rises, saving increases and becomes equal to
investment
4. The theory ignores role of money as a store of value,
and assumes money to be neutral, merely acting as a
medium of exchange
 In doing so, the classical theory of interest doesn’t take
into account the possibility that saving may be hoarded
without being invested
5. The classical economists included only saving in the
supply
56
of capital
 ……Continued
 But in reality, the supply of capital comprises of dishoarded
money
 Moreover, newly created money and bank credit also form
important sources of supply of capital
6. According to the classical theory, the demand for capital
comes only from the investors for meeting investment
expenditures
 It completely ignores the fact that loans are also taken for
consumption purposes and just for hoarding it
6. Loanable Funds Theory of Interest
 The loanable funds theory, also known as the neo-classical
theory, is an attempt to improve upon the classical theory
of Interest
 According to this theory, the rate of Interest is the price of
credit which is determined by the demand and supply of
57 loanable funds
 ……Continued
 The term ‘loanable funds’ refers to the total amount of
money which is supplied and demanded in the market
 According to loanable funds theory, interest is the price
paid for the use of loanable funds
 There are several sources of both supply and demand for
loanable funds
Supply of Loanable Funds
 The supply of loanable funds comes from savings,
dishoarding and bank credit
 Private savings, which is the sum of individual and
corporate savings, are the main source of savings
 Though personal savings depend upon the income level,
they are regarded as Interest elastic if we take the level of
income as given
 The higher the rate of Interest, the greater will be the
58
inducement to save and vice-versa
 ……Continued
 Dishoarding also brings forth the supply of loanable
funds
 When people dishoard the previous hoardings, the
supply of loanable funds increases
 At higher rate of interest, more will be dishoarded
 Money created by banks adds to the supply of loanable
funds
 By creating credit money, banks advance loans to the
businessmen
 Generally, the banks will lend more money at higher
rates of interest
 So, all in all, higher interest rates encourage lenders to
lend more, and thus supply of loanable funds slopes
59
upward
 ……Continued
Demand for Loanable Funds
 The demand for loanable funds has three sources namely
government, businessmen and consumers who need them
for purposes of investment, hoarding and consumption
 The government demands funds for the provision of public
goods, for development purposes or for war
 On the part of business firms, loanable funds are
demanded for purchasing or producing new capital goods
and for starting investment projects
 The demand for loanable funds on the part of the
consumers is for the purchase of durable consumer goods
like houses, refrigerators, television sets, etc.
 Funds are also demanded for the purpose of hoarding them
in liquid form as idle cash balances
 Since rate of interest is the price of the loanable funds,
lower rates of interest will induce them to borrow more
 Hence demand curve for loanable funds, for all parties (the
60
government, investors, & consumers), is downward sloping
 ……Continued
Determination of Interest Rate
 The rate of interest is determined by the equilibrium
between the total demand for loanable funds and the
total supply of loanable funds

Rate of Interest (R)

DDL SSL

E
R*

O L* Loanable Funds (L)

 In the diagram, demand for loanable funds (DDL) and

61 supply of loanable funds (SSL) meet at point E
 ……Continued
 Therefore, E will be the equilibrium point and R* will
be the equilibrium rate of interest
 At this rate of interest, demand and supply of loanable
funds are in balance, both being equal to L*
 Criticisms of the Theory
1. The classical writers noted the effect of money on the
rate of interest through the saving - investment process
 Hence, the loanable funds theory is not a new theory
2. In most modern economies, the rate of interest is not
determined by the market forces, but by institutional
forces, i.e., by the policies and actions of central banks
and governments
 Their policies exert the most important influence on
the rate of interest by determining both the demand
62
for and supply of loanable funds in the country
 ……Continued
3. Another criticism against the loanable funds theory is that
it is based upon the assumptions of full employment of
resources
 However, the theory takes into account the increase in the
level of income due to investment and its influence on
savings
 If full employment is assumed, income would not increase
at all
4. Like the classical theory, the loanable funds theory
exaggerates the effect of rate of interest on savings
 That is to say, generally speaking, people save not to earn
interest, and interest cannot be regarded as the reward for
savings as savings in the form of idle cash balances do not
63
bring any interest