INTEREST THEORIES

1. Productive Theory
- Interest can be defined as a reward for availing the services of capital for the
production purpose.
- Pure interest is the same in money market during the same period of time.
- Labor that is having good amount of capital produces more as compared to the labor
who is not assisted by good amount of capital.

2. Abstinence Theory
- Interest is a reward for abstinence. When an individual saves money out of his/her
income and lends it to other individual, he/she makes sacrifice
- The term sacrifice implies that the individual refrains from consuming his/her whole
income that he/she could spent easily.
- According to the theory, an individual feels unpleasant when they save as it reduces
his/her consumption. However, rich people do not feel unpleasant while saving
because they are able to meet their requirements.

3. Austrian or Agio Theory

- The “psychological theory of interest”,
- Interest came into existence because present goods are preferred over future
goods. Therefore, the present goods have premium with them in the form of
interest. In other words, present satisfaction is of greater concern as compared to
future satisfaction.
- Future satisfaction has certain type of discount if compared with present
satisfaction. The interest is the discounted amount that is required to be paid for
motivating people to invest or transfer their present requirements to future.
- This theory was advocated by John Rae and Bohm Bawerk in an Austrian School

4. Classical or Real Theory

- Helps in the determination of rate of interest with the help of demand and supply
forces.
- Demand refers to the demand of investment and Supply refers to the supply of
savings.
- According to this theory, rate of interest refers to the amount paid for saving.
- Therefore, the rate of interest can be determined with the help of demand for
saving money to be invested in the capital goods and the supply of savings.
- Capital goods are used for the production of consumer goods and provide returns
continuously for many years.

5. Loanable Fund Theory

- “neo-classical theory of interest”
 - According to neo-classical economists, interest is the amount paid for loanable
funds. It focuses on the determination of rate of interest with the help of demand
and supply of loanable funds in the credit market.
- Interest is the amount paid for loanable funds.
- It agrees with the view that time preference plays an important role in determining
the occurrence of interest.
- The higher rate of interest demotivates organizations to buy capital goods or expand
their stock of capital goods. Therefore, the demand of loanable funds is interest
elastic for organizations; therefore, the demand curve would slope downwards.

Inflation vs. Deflation

Inflation- Gain Deflation- Loss
INFLATION DEFLATION
Occurs when the price of goods and services occurs when those prices decrease.
rise
is a quantitative measure of how quickly the is the general decline in prices for goods and
price of goods in an economy is increasing. services occurring when the inflation rate
falls below zero percent.

Inflation lowers your standard of living if your Deflation could cost you your job. If prices
income doesn't keep pace with rising prices. continue to decline, your employer may not
Most of the time, it rarely does. be able to remain profitable. To stay in
business, there may be layoffs. If deflation
continues long enough, many people will lose
their jobs.

It is the continuous upward It is the decrease in the general price

movement in the general price level level, in the country’s economy.
of the economy.

- The balance between the two economic conditions, opposite sides of the same coin,
is delicate and an economy can quickly swing from one condition to the other.
- Both can be good or bad for the economy, depending on the underlying reasons and
rate.

How do you think it would affect the investment?

- Inflation: The goal with an investment is to increase returns and long-term
purchasing power, but inflation puts this goal at risk. As inflation increases, the value
of the investment diminishes, and the consumer ends up paying more for less
because of the decreased value of the dollar.
 - Inflation has the same effect on liquid assets as any other type of asset, except that
liquid assets tend to appreciate in value less over time. This means that, on net,
liquid assets are more vulnerable to the negative impact of inflation. In terms of the
broader economy, higher rates of inflation tend to cause individuals and businesses
to hold fewer liquid assets.
- Illiquid assets are also affected by inflation, but they have a natural defense if they
appreciate in value or generate interest. One of the chief reasons most workers
place money into stocks, bonds and mutual funds is to keep their savings safe from
the effects of inflation. When inflation is high enough, individuals often convert their
liquid assets into interest-paying assets, or they spend the liquid assets on consumer
goods.

- Deflation is generally considered to have a negative impact on stocks since lower

prices over a long time frame tend to hurt bottom-line corporate net income.

Moreover, deflation can encourage consumers to save money and reduce spending,
negatively impacting top-line revenues—thereby eroding shareholder value. While
deflation is bad for stocks, it can have a positive impact on bonds.

Negative Interest Rate

- refer to a scenario in which cash deposits incur a charge for storage at a bank, rather
than receiving interest income.
- Instead of receiving money on deposits in the form of interest, depositors must pay
regularly to keep their money with the bank.
- This environment is intended to incentivize banks to lend money more freely.
- With negative interest rates, cash deposited at a bank yields a storage charge, rather
than the opportunity to earn interest income.
- Negative interest rates might be seen during deflationary periods when people or
institutions are inclined to hoard money, rather than spend or lend it.
- The negative interest rate is meant to be an incentive for banks to make loans during
a period in which they would rather hang on to funds.

How Does a Negative Interest Rate Work?

- While real interest rates can be effectively negative if inflation exceeds the nominal
interest rate, the nominal interest rate had been theoretically bounded by zero.
Negative interest rates are often the result of a desperate and critical effort to boost
economic growth through financial means.

- Negative interest rates may occur during deflationary periods when people and
businesses hold too much money instead of spending. This can result in a sharp
decline in demand, and send prices even lower. Often, a loose monetary policy is
used to deal with this type of situation. However, with strong signs of deflation still a
factor, simply cutting the central bank's interest rate to zero may not be sufficient
enough to stimulate growth in credit and lending.
 - In a negative interest rate environment, an entire economic zone is impacted as the
nominal interest rate dips below zero and banks and other firms have to pay to store
their funds at the central bank, rather than earn interest income.

Curve Yields vs. Flat Yields

Curve Yields
- A yield curve is a line that plots yields (interest rates) of bonds having equal credit
quality but differing maturity dates.
- The slope of the yield curve gives an idea of future interest rate changes and
economic activity.
- There are three main types of yield curve shapes: normal (upward sloping curve),
inverted (downward sloping curve) and flat.
- This yield curve is used as a benchmark for other debt in the market, such as
mortgage rates or bank lending rates, and it is used to predict changes in economic
output and growth.
- Yield curves plot interest rates of bonds of equal credit and different maturities.
- The three key types of yield curves include normal, inverted and flat. Upward sloping
(also known as normal yield curves) is where longer-term bonds have higher yields
than short-term ones.
- Yield curve rates are published on the treasury’s website each trading day

Flat Yields
- Annual interest on a fixed-income security (without taking into account any capital
gain or loss on redemption) divided by the security's price and expressed as a
percentage
- Formula: Security's annual interest rate x 100 ÷ security's market price.
- A flat yield curve may arise from the normal or inverted yield curve, depending on
changing economic conditions. When the economy is transitioning from expansion
to slower development and even recession, yields on longer-maturity bonds tend to
fall and yields on shorter-term securities likely rise, inverting a normal yield curve
into a flat yield curve.
- When the economy is transitioning from recession to recovery and potential
expansion, yields on longer-maturity bonds are set to rise and yields on shorter-
maturity securities are sure to fall, tilting an inverted yield curve toward a flat yield
curve.

A normal yield curve is one in which longer maturity bonds have a higher yield compared to
shorter-term bonds due to the risks associated with time.

An inverted yield curve is one in which the shorter-term yields are higher than the longer-term
yields, which can be a sign of an upcoming recession.
In a flat or humped yield curve, the shorter- and longer-term yields are very close to each other,
which is also a predictor of an economic transition.

While normal curves point to economic expansion, downward sloping (inverted)

curves point to economic recession.

Example on the investment that would generate firm from curve yields to flat yields

For example, a flat yield curve on U.S. Treasury bonds is one in which the yield on a two-year
bond is 5% and the yield on a 30-year bond is 5.1%.

A flattening yield curve may be a result of long-term interest rates falling more than short-term
interest rates or short-term rates increasing more than long-term rates. A flat yield curve is
typically an indication that investors and traders are worried about the macroeconomic
outlook. One reason the yield curve may flatten is market participants may be expecting
inflation to decrease or the Federal Reserve to raise the federal funds rate in the near term.

For example, if the Federal Reserve increases its short-term target over a specified period, long-
term interest rates may remain stable or rise. However, short-term interest rates would rise.
Consequently, the slope of the yield curve would flatten as short-term rates increase more than
long-term rates.

For example, assume the yield spread is 8%, and an investor believes the yield curve will flatten.
The investor could allocate half of the fixed-income portfolio to U.S. Treasury 10-year notes and
the other half to U.S. Treasury two-year notes. Therefore, the investor has some flexibility and
could react to changes in the bond markets. However, the portfolio may experience a
significant fall if there is a meteoric increase in long-term rates, which is due to the duration of
long-term bonds.