Preparing for the JAIIB IE & IFS exam requires a strong understanding of economic concepts, and Theories of Interest is one of the most important as well as challenging topics in Module B. This chapter covers different approaches to the determination of the rate of interest, including the Classical Theory, Keynes’ Liquidity Preference Theory, and the Hicks-Hansen IS-LM Model. Many candidates find these concepts difficult because they involve both real and monetary factors along with graphical analysis. In this blog, we have provided all the details about the important concepts of Theories of Interest and download a PDF for revision and practice.
What are the theories of interest in JAIIB IE & IFS?
Theories of Interest explain how the rate of interest is determined in an economy. Different economists have provided different explanations based on savings, investment, demand for money, and supply of money. The JAIIB syllabus mainly covers three major theories that every banking aspirant should understand clearly before attempting the examination.
| Theory | Main Idea | Rate of Interest Depends On |
| Classical Theory | Real factors determine interest | Savings and Investment |
| Keynes’ Theory | Monetary factors determine interest | Demand for Money and Supply of Money |
| Hicks-Hansen Theory | Combines both approaches | Savings, Investment, Money Demand and Money Supply |
Download Practice Quiz on Theories of Interest
Strengthen your JAIIB IE & IFS preparation with a dedicated Theories of Interest Practice Quiz PDF. It covers important topics such as the Classical Theory of Interest, Keynes’ Liquidity Preference Theory, Hicks-Hansen IS-LM Model, demand and supply of money, savings and investment, fiscal policy, monetary policy, and equilibrium rate of interest.
Attempt Quiz on JAIIB IE & IFS Theories of Interest
Evaluate your understanding of Theories of Interest with this topic-wise practice quiz. The MCQs cover Classical Theory, Keynes’ Theory, IS-LM Model, liquidity preference, money demand and supply, interest rate determination, and other frequently asked JAIIB IE & IFS concepts.
1. Which of the following is NOT an alternative name used for the Classical Theory of Interest?
2. Which group of economists is most closely associated with propounding the Classical Theory of Interest?
3. As per the Classical Theory, the rate of interest is determined by the equilibrium of:
4. In the framework describing the three elements of an interest payment on a loan, which of the following is NOT one of them?
5. ‘Pure interest’, in the classical sense, is determined by:
6. Under the Classical Theory, the demand for savings (i.e., demand for capital/investment) primarily originates from:
7. According to the Classical Theory, the demand for capital (investment) depends mainly on:
8. As per classical reasoning, when the quantum of investment increases progressively, the marginal productivity of capital tends to:
9. Under the Classical Theory, borrowers will undertake investment (borrowing) only when:
10. In the Classical framework, the supply of savings depends on all of the following EXCEPT:
11. In classical economics, the act of saving essentially represents:
12. As per Classical Theory, when the level of income in the economy rises, the supply of savings tends to:
13. Under the Classical Theory, a rise in the rate of interest is expected to cause:
14. The equilibrium rate of interest, as defined under the Classical Theory, is the rate at which:
15. Which of the following statements correctly reflects the Classical view on the equilibrium interest rate across different income levels?
16. Keynes’s principal criticism of the Classical Theory of Interest was that:
17. According to Keynes, the level of investment in an economy is primarily governed by:
18. As per Keynes, savings in an economy are determined mainly by:
19. Keynes’s theory of interest, presented in “The General Theory of Employment, Interest and Money”, is also known as the:
20. As per Keynes, the demand for money arises from all of the following motives EXCEPT the:
Quiz Summary
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What is meant by the rate of interest?
The rate of interest is the price paid for borrowing money or the return earned by lending or investing money. It acts as a reward for giving up the present use of money for future benefits. In economics, understanding how this rate is determined helps explain investment decisions, borrowing behaviour, and monetary policy.
- Interest is paid on borrowed money.
- It is one of the four major factor incomes.
- It is also the return earned on investments.
- The market rate of interest changes based on economic conditions.
- Different economic theories explain how this rate is determined.
What is the Classical Theory of Interest?
The Classical Theory is also known as the Saving-Investment Theory or Real Theory of Interest. According to classical economists, the rate of interest is determined by the equilibrium between savings and investment. It assumes that people save part of their income, while businesses demand these savings for investment.
| Factor | Explanation |
| Supply of Funds | Comes from household savings |
| Demand for Funds | Comes from business investment |
| Equilibrium | Savings = Investment |
| Nature | Real factor theory |
| Alternative Names | Saving-Investment Theory, Capital Theory |
How is the demand for savings explained in the Classical Theory?
Businesses borrow money to invest in productive activities. They compare the expected return on investment with the cost of borrowing. If borrowing costs are low and returns are high, investment demand increases. As interest rates rise, businesses borrow less because the cost becomes higher.
- Expected return on investment
- Marginal productivity of capital
- Cost of borrowing
- Business expectations
- Prevailing rate of interest
Also: Check out the detailed JAIIB IE and IFS Syllabus
What determines the supply of savings?
The supply of savings depends on people’s willingness and ability to save. Individuals postpone present consumption to save for future needs. Higher income generally increases the amount people can save, while personal habits and financial goals also influence savings.
- Income level
- Capacity to save
- Willingness to save
- Patience for future consumption
- Economic and psychological factors
Why was the Classical Theory criticised?
Although the Classical Theory explains interest through savings and investment, economists pointed out several limitations. The biggest criticism was that it ignored the important role played by money in determining the interest rate.
| Limitation | Explanation |
| Ignores money market | Does not consider money demand and supply |
| Savings not highly interest-sensitive | Income affects savings more than interest |
| Investment depends on expectations | Future business outlook also matters |
| One-sided approach | Focuses only on real factors |
What is Keynes’ Liquidity Preference Theory?
John Maynard Keynes introduced the Liquidity Preference Theory in his famous book The General Theory of Employment, Interest and Money. According to Keynes, the rate of interest is determined by the demand for money and the supply of money. Therefore, interest is considered a monetary phenomenon instead of a real phenomenon.
| Component | Explanation |
| Demand for Money | People want to hold cash |
| Supply of Money | Controlled mainly by the central bank |
| Interest Rate | Determined where money demand equals money supply |
| Nature | Monetary theory |
Why do people demand money according to Keynes?
Keynes explained that people hold money for different reasons. These reasons are called motives for holding money. Understanding these motives is very important for JAIIB examinations.
| Motive | Purpose |
| Transaction Motive | Daily expenses and business payments |
| Precautionary Motive | Future emergencies and unexpected expenses |
| Speculative Motive | To earn better returns in future investments |
What is the relationship between bond prices and interest rates?
Bond prices and interest rates always move in opposite directions. This inverse relationship is frequently tested in banking examinations and forms the basis of Keynes’ speculative demand for money.
- Higher interest rate → Lower bond price
- Lower interest rate → Higher bond price
| Interest Rate | Bond Price |
| Increases | Falls |
| Decreases | Rises |
Also Check: JAIIB IE and IFS Study Material
How is the equilibrium rate of interest determined in Keynes’ Theory?
According to Keynes, equilibrium is achieved when the demand for money becomes equal to the supply of money. At this point, the economy reaches its equilibrium interest rate.
- Money demand curve slopes downward.
- Money supply curve is generally vertical.
- Their intersection determines the equilibrium interest rate.
- The central bank influences money supply through monetary policy.
What is the Hicks-Hansen IS-LM Model?
The Hicks-Hansen Model combines the Classical Theory and Keynes’ Theory into one framework. It explains that both real factors and monetary factors jointly determine the equilibrium rate of interest and national income.
| Curve | Represents |
| IS Curve | Savings and Investment Equilibrium |
| LM Curve | Money Demand and Money Supply Equilibrium |
| Intersection | Equilibrium Interest Rate and Income |
What do the IS and LM curves represent?
The IS curve represents equilibrium in the goods market, while the LM curve represents equilibrium in the money market. Their intersection gives the economy’s overall equilibrium.
| IS Curve | LM Curve |
| Downward sloping | Upward sloping |
| Goods Market | Money Market |
| Savings = Investment | Money Demand = Money Supply |
| Real Factors | Monetary Factors |
How does fiscal policy affect the IS-LM model?
Government spending and taxation mainly affect the IS curve. Expansionary fiscal policy increases income and interest rates, whereas contractionary fiscal policy reduces both.
| Policy | IS Curve | Interest Rate | Income |
| Expansionary | Right Shift | Increases | Increases |
| Contractionary | Left Shift | Decreases | Decreases |
Also Check: JAIIB IE and IFS Mind Map PDF
How does monetary policy affect the IS-LM model?
Monetary policy mainly shifts the LM curve. When the central bank increases money supply, interest rates fall and investment rises. When money supply decreases, borrowing becomes costly and economic activity slows down.
| Policy | LM Curve | Interest Rate | Income |
| Expansionary | Right Shift | Falls | Rises |
| Contractionary | Left Shift | Rises | Falls |
FAQs
The syllabus covers the Classical Theory, Keynes’ Liquidity Preference Theory, and the Hicks-Hansen IS-LM Model.
It explains that the rate of interest is determined by the equilibrium between savings and investment.
It states that the rate of interest is determined by the demand for money and the supply of money.
The IS-LM Model combines real and monetary factors to explain the equilibrium interest rate and income level.
Keynes’ Liquidity Preference Theory considers interest to be a monetary phenomenon.
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