Theory of Interest Research Paper Starter

Theory of Interest

This paper addresses a critical component of Keynesian economics — his theory of interest. In addition to an overview of his works as well as modern, "neo-Keynesian" versions of his principles, the reader also gleans an understanding of the debate surrounding the applicability of Keynesian thought in a 21st century economic environment.

Keywords Capacity Utilization; Capital Assets; Interest; Liquidity Preference; Macro-economy; Wage Unit

Actuarial Science: Theory of Interest


Unbeknownst to many, John Maynard Keynes originally wanted to operate a railroad. Unfortunately, however, to do so, he had to pass a civil service examination, and the man who would become known as the "father of modern economics" received his lowest marks on the economics section. As Keynes would later recall, I evidently knew more about economics than my examiners" ("Young John Maynard Keynes," 2007).

While Keynes' pursuit of a career on the rails did not come to fruition, his lack of discouragement at the civil service examiners' led him to become a central figure in the reinvigoration of the western economy after the Great Depression and World War II. His theories on economic development reshaped the international community's perspective on how to address the ongoing fiscal crisis and left an impact on global economics that prevails today.

Of course, such accolades do not suggest that Keynes was free of controversy. In fact, Keynes' view that government must play a role in the revitalization of national economies, and that the goal of economic redevelopment should be to bolster the demand side of a macroeconomy, made him a target for those fearful of a leftist ideology in rebuilding the systems of the West. Even today, in the 21st century, Keynesian economics are consistently under fire by free market proponents and conservatives who view his theories as overly simplistic and even impractical in today's global economy.

This paper addresses a critical component of Keynesian economics — his theory of interest. In addition to an overview of his works as well as modern, "neo-Keynesian" versions of his principles, the reader gleans an understanding of the debate surrounding the applicability of Keynesian thought in a 21st century economic environment.

Keynes & the Future of Economics

In 1936, countries around the globe were mired in the Great Depression. Classical economic theories suggesting that the free market would correct itself (so-called laissez-faire economics; introduced by icons such as Adam Smith and John Stuart Mill) proved largely ineffectual in revitalizing the economies of the western world. A new approach was clearly warranted, and the thinking of John Maynard Keynes seemed to offer just that alternative.

In his seminal work, "General Theory of Employment, Interest and Money," Keynes advocated for a government that played a more significant role in economic affairs. By infusing monies into the demand side of the macroeconomy, Keynes suggested, economic systems under duress from recession and depression could become reinvigorated by increased consumer confidence, higher incomes and a workforce well-suited to contribute to the economy.

Keynes' argument in that work was based on acknowledgement of three central, independent variables.

  • The first of these was a combination of psychological factors: Propensity to consume, the attitude concerning liquidity and an expectation of future yield from capital assets.
  • Second, Keynes posited, was the wage unit, which is determined by the bargains reached between employees and their employers.
  • The last of these variables, Keynes argued, is the quantity of monies as determined by the central bank.

At the core of the interaction between these variables is what Keynes called the "liquidity preference schedule." Consumers, Keynes theorized, were in essence in control of the rate of interest (which is a price which a lender may charge a borrower in a loan situation). They could therefore choose to hoard their monies and assets or invest them in the markets, depending on how much in liquid assets they possessed. Keynes asserted that this choice would be a powerful determinant of the rate of interest. If national incomes and employment rates remained static, a state of equilibrium would exist. However, Keynes assumed that this equilibrium would not be consistent in light shifts in liquidity caused by changes in consumer behavior (Lutz, 2006).

As was the case for the predominance of Keynes' "General Theory," the focus is on the demand side of a macroeconomy. Keynes asserted that governments seeking to reinvigorate their own economies through intervention (a shift in and of itself from the pure free-market economic model preferred by Classical theorists) must focus on the consumer. In terms of his views on interest specifically, the consumer's attitudes concerning the economy would drive whether or not he or she will spend his or her liquid assets or retain it. Depending on the direction in which consumer behavior leads, rate of interest shifts.

As stated earlier, J.M. Keynes' notions introduced in "General Theory" were at best controversial. Part of the debate centered around the fact that his theory of interest was largely dependent upon ideas he proffered in a work published six years prior: "A Treatise on Money." In "Treatise," Keynes laid the groundwork for an argument that, in simplified terms, asserted that investment leads to inflation and savings to recession. The connection between the two works became frayed, due in part because debate with mainstream economists brought about modifications to Keynes' framework that disconnected "General Theory" from "Treatise" (Erturk, 2006).

Keynes' ideals created a firestorm of debate, but the controversy did not stem solely from those who maintained a conservative loyalty to the Classical approach. There were many who at the time saw Keynes' work as needy of further exposition in order to ensure true validity. It is to this contemporary debate surrounding Keynes' theories that this paper turns next.

Peer Debate Over the Keynesian School of Thought

Keynes' theories understandably set off controversy and invited pointed criticism. Some of it was politically motivated. After all, to free market conservatives (many of whom were actively concerned with the spread of communism) the idea that government should play an active role in a western economy smacked of leftist ideology akin to Marxism. For others, Keynes was simply attempting to turn the establishment on its ear for revolution's sake.

Among the critiques was that of Friedrich August von Hayek, whose ideas would evolve into the school of thought known as Austrian economics. Hayek originally dismissed Keynes' theory of liquidity preference as far too rigid and only applicable in emergency situations in which the balance between supply and demand are in immediate peril. Hayek's views of Keynes, the "General Theory" and the liquidity preference were later revealed to be based on misinterpretation of Keynes' central message. In fact, Keynes made a point, in trying to help critics understand his ideas, of asserting that his main focal point, liquidity preference, was not the singular element in determining the interest rate (DeVecchi,...

(The entire section is 3230 words.)