Question

In: Economics

What is meant by Interest in Economics?

What is meant by Interest in Economics? Define. 

What are the theories of Interest? Only name them. 

Solutions

Expert Solution

INTEREST -

 

interest is a amount which is paid by the borrower to the lender in addition to the principal amount borrowed by him. As we know, money is a purchasing power which can be easily transferred from one person to another. When this transfer of money is done in exchange for any product or service. then this receiver get the money of for goods. However, money is often transfer temporarily, in which receiver of money returned back the money to the person from whom it was taken. This is called borrowing and lending of money. This borrower, when the returns the money, has to pay back some extra money. This extra money is the price for that borrowing. This is called interest. In this way we can say that interest is the price paid by the borrower to the lender for the use of funds. This is ordinarily expressed as percentage per annum.

Interest rate may be expressed in two ways.

(i).  Pure Interest Rate

(ii).  Gross Interest Rate

Pure interest rate is that rate which is a payment for the use of funds. It is the time value of money. However, the transactions taking place in the market are not at the pure rate of interest, there are other aspect also. If there is a risk in lending, then the lender would like a premium on the pure rate of compensate for the extra risk. As the magnitude of risk increases, this risk premium also increases. Similarly, every transaction involves some expenditure of money like the stamp duty, transportation expense or other administrative expense. When we add these  expenses in the pure rate we get the market rate or the Gross rate of interest. Hence

 

Gross Rate of Interest =

Pure Interest Rate + Risk Premium + Administrative Expenses

 

Theories of INTEREST -

 

Before the modern age, interest was always looked upon with suspicion. Many thinkers did not consider interest as justified, because they thought that when the borrower pays back the borrowed money, what is justification for interest. Islam, always considered interest as unjust and condemned it. Inspite of these thoughts, interest has always existed and economists always considered it to be just and essential. Several theories have prevailed in economics which had justified interest, some of which are mentioned below:

1.   Productivity Theory

2.  Waiting Theory

3.  Time Preference Theory

4.  liquidity Preference Theory


Interest is an amount which is paid by the borrower to the lender in addition to the principal amount borrowed by him. 

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