What is Interest? | Microeconomics

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Meaning of Interest:

In the modern large-scale production system of a country, capital is a very important input. The price that the owner of capital should be paid for using this input in the production of goods and services is called interest in economics.

As a factor of production, capital has two forms:

(i) Money or loan capital and

(ii) Real capital.

If a business firm uses its savings for purposes of production, i.e., to buy different inputs, then the savings are converted into capital. Again, in order to buy different factor inputs, if the firm borrows money which must have come from some savers, then also, this borrowed money is called money capital or loan capital.

Now, if the firm buys a machine with the help of money capital, then the latter is converted into real capital, because machines are real capital. Here the owners of the money capital are those persons who have given the firm the loan for buying the machines.

So long as this loan is not repaid, the firm would go on paying the owners of capital the price of using the capital at a fixed time-rate. This price for using the capital is, by definition, the rate of interest.

For exam­ple, if the firm borrows Rs 10,000 to buy a machine and makes a contract with the lender of the money that so long as this money is not repaid, it would go on paying him Rs 1,000 per year, then the annual rate of interest in this case is 10 per cent, which is the price of capital.

Since the firm uses the loan capital to buy the machine, we may consider the rate of interest paid (i.e., 10 per cent per year) as the price of using the machine or the real capital. That is, interest may be taken to be the price of using the loan capital, or, it may be considered as the price of using the (stock of the) real capital that has been obtained by spending the money capital.

We have to remember here that the firm is willing to pay interest for using any particular amount of capital, because the rate of its output production would be (much) more if it uses the capital in the form of machines and equipment’s than the rate of output obtained without using them.

On the other side, the owners of money capital are willing to lend the money only when they are to get a price in the form of interest, because as they lend out the money, they have to deprive themselves of some of the requirements of present consumption.

Gross Interest and Net Interest:

By definition, the price or interest that the owners of capital receive for lending out their capital, i.e., for letting their capital to be used in a production process, is net interest. In reality, of course, the interest the owners of capital get for lending out their money is called gross interest.

Generally, gross interest is higher than net interest. Because gross interest is the price for using the capital, i.e., net interest plus some other items of cost associated with the transactions of loans. These other items of cost arise as given below.

First, the lender has to bear some risk while lending out his money. For there is uncertainty as to whether the borrower would repay the loan in time. For example, the borrower may die before repaying the loan or he may become bankrupt, being unsuccessful in business.

He may even refuse to pay interest or repay the loan in time even when he is financially sound. There­fore, not only the price for using the capital, but also some rewards for bearing the risks in­volved are included in gross interest.

Second, the lender has to bear some incidental expenses for giving up his money in loans. For example, he would have to obtain the information of where to lend his money and at what rate of interest.

Also, he would have to decide how he should distribute the money to be loaned out among the different sectors of the capital market. Now, since the lender himself has to bear the costs for administering these requirements, these costs should be included in gross interest.

Third, if the economy faces an inflationary situation, then the real value of capital decreases as there is a general price rise. For example, if a sum of Rs 10,000 is loaned out today for a period of five years, and if price rise continues during this period, then after five years, when the principal amount is received back, much of the real value of money would have eroded.

Therefore, if the owners of capital are to be safeguarded against the loss due to inflation, then the cost of inflation should be included in gross interest.

In the above discussion, we have seen that the reward the owners of capital receive for lending out their money is called gross interest. Apart from net interest or the price for the use of capital only, gross interest includes some other types of cost. If we deduct all these other types of cost from gross interest, we obtain the net interest.