‘Real’ Versus ‘Monetary’ Theories of the Rate of Interest | Macro Economics

The upcoming discussion will help you to compare between real and monetary theories of the rate of interest.

The classical theories of the rate of interest focus their attention upon the “real” factors of productivity and thrift.

The action of monetary authorities in recent decades and the presence of unemployment have seriously diluted the impact of the real forces contemplated in these theories.

As a result, economists have largely ceased to be concerned with real theories of interest.

The popular theory of interest today is either a liquidity preference theory, in which money rate of interest depends on the demand and supply of the stock of bonds, or a loanable funds theory’ in which the money rate of interest depends on the demand and supply of a flow of securities.

It is sometimes suggested that there is a conflict between real and monetary theories of interest. According to real theories, interest is the yield of capital and a reward for abstaining from present consumption. According to monetary theories, interest is the price of money and a reward for parting with liquidity. These are supposed to be inherently conflicting explanations.

Keynes himself seems to have fostered this interpretation when he stated dogmatically that interest is not a reward for waiting but a reward for not hoarding money. But general equilibrium considerations must show that interest operates simultaneously, as D.H. Robertson has put it on “the threefold margin” of consumption decisions, investment decisions, and asset-portfolio decisions.

In other words, interest simultaneously rewards waiting, reflects the pure yield of capital and compensates for the sacrifice of liquidity. The only proviso we need to add to this conclusion is that waiting is a private as well as a social cost, whereas parting with liquidity is only a private cost.

Society cannot choose between lending for investment and the safety of cash. From the social point of view, capital can be hold in real terms only in the form of goods, and this is never safe or liquid: no choice is involved because un-invested savings are irretrievably lost to society.

Since the monetary authorities admittedly exercise an enormous influence on the rate of interest now-a-days, how much significance should we attach to real theories of interest? Professor Don Patinkin offers a way of answering this question. A real theory determines the interest rate in the commodity market, while a monetary theory determines it either in the bond market or in the money market.

We can say that interest is a real phenomenon if it behaves like an absolute price. It has to be noted that changes in the quantity of money and in liquidity preference which leave relative prices unchanged also leave the rate of interest in variety.

On the other hand, technical change that affects the yield of capital and changes in time preference that affect saving decisions alter relative prices and also alter the rate of interest. The forces that have changed absolute prices over time have had little effect on the long-run rate of interest. In that sense, we can conclude that the long-term rate is essentially a matter of real forces.

The Synthesis of the ‘Real’ and ‘Monetary’ Theories:

We have, studied the real theory, the liquidity preference theory and the loanable funds theory, the latter two being monetary theories. Which theory to keep and which to reject? Strictly speaking, the rate of interest is affected in some degree by all of the elements expressed in the equation of the Walras-Hicks general equilibrium system.

Hence either the loanable-funds approach or the liquidity preference approach represents a form of partial equilibrium analysis of the determinants of the rate of interest.

A correct view of the determination of the rate of interest can be taken only by considering the rate of interest to be determined in a general equilibrium system. The reconciliation of the two monetary theories and the “real” theory can best be effected, therefore, by taking a somewhat broader view of the economy than anyone of these three theories ordinarily takes.