Modern Theory of Interest In Economics

Hicks and Hansen has developed the Modern Theory of Interest. This theory has combined together the monetary and non-monetary factors to seek an explanation of the determination of the rate of interest.

According to Modern Theory of Interest, there are four determinants of the rate of interest. These are the savings, investment, liquidity preference, and money supply. To get a satisfactory explanation to the rate of interest, the modern theory involved two curves, namely, IS curve and LM curve. The IS curve shows the equilibrium in the real sector while the LM curve represents the equilibrium in the monetary sector. The point of intersection of the two curves, namely, IS and LM gives us the equilibrium rate of interest. At this rate of interest both the real as well as monetary sectors are in equilibrium. At this rate, total savings will be equal to the total investment and total demand for money will be equal to the total supply of money.

Determination of Interest : The IS curves slopes downwards from left to right because as the rate of interest falls, investment and income increases. The LM curve rises upwards from left to right because as the rate of interest falls, demand for money falls. The point where these two curves, IS and LM curves, intersect is the general equilibrium rate of interest that brings the two sectors into equilibrium. This is shown in the following diagram:

In the diagram IS curve shows the equilibrium rate of interest in the savings and investment sector at various levels of income. The LM curve shows the equilibrium rate of interest in the monetary sector at different levels of income.

These two curves intersect each other at point E. Here, OR is the general equilibrium rate of interest that brings both the real and monetary sectors into equilibrium. At ‘OM’ level of income and at ‘OR Interest rate, savings are equal to investment and demand for money is equal to the supply of money.

Improvement Of Modern Theory of Interest over Keynesian Theory:

The modern theory of Interest is certainly an improvement over the Keynesian theory of interest because it deals with both the real and monetary factors. The Keynesian theory deals only with the monetary factors, not the real factors. As such the modern theory of interest is much more comprehensive than the Keynesian theory of interest.