Theories of Interest · One-liners

1 What are the three components hidden in every quoted interest rate?

Risk premium, service charge, pure interest (time-value of money).

2 How does Keynes' theory fundamentally differ from Classical interest theory?

Interest determined by money demand/supply, not saving and investment.

3 In Keynes' two-asset world, which asset earns interest but has price volatility?

Long-term bonds; prices move inversely with interest rates.

4 State the three motives for holding money in Keynesian theory.

Transactions, precautionary, speculative motives for liquidity preference.

5 What is the slope and logic of the Money Demand (LP) curve?

Downward-sloping; lower rates increase money holding as bonds yield less.

6 How does RBI money supply increase affect interest rates per Keynes?

Excess supply pushes rates down until public willing to hold larger stock.

7 What is the IS-LM model? Who created it?

Hicks-Hansen synthesis merging commodity (IS) and money market (LM) equilibrium.

8 Why is the IS curve downward-sloping?

Higher income increases saving, lowering equilibrium interest rate in commodity market.

9 Why is the LM curve upward-sloping?

Higher income increases money demand; with fixed supply, equilibrium rate rises.

10 What does the IS-LM intersection point determine?

Equilibrium interest rate and equilibrium income where both markets clear simultaneously.

11 List four factors jointly determining interest rate in IS-LM theory.

Investment demand, saving function, liquidity preference, quantity of money (RBI).

12 What does 'IS' stand for in IS-LM model?

Investment equals Saving; commodity market equilibrium condition.

13 What does 'LM' stand for in IS-LM model?

Liquidity equals Money; money market equilibrium from Keynes' theory.

14 How does RBI Repo Rate operate as LM-shifter in IS-LM framework?

Changes Repo rate to shift LM curve, adjusting both equilibrium r and Y.

15 How are retail loans (home, auto, MSME) linked to Repo Rate since Oct 2019?

External benchmark linked to Repo Rate (EBLR); mechanically transmit MPC changes.

16 What is the relationship between bond prices and interest rates?

Inverse: bond prices fall when rates rise, rise when rates fall.

17 Define equilibrium rate of interest in money market.

Rate at which quantity of money demanded equals quantity supplied by RBI.

18 What does Hicks–Hansen synthesis add to Keynes' framework?

Derives IS from S=I, LM from L=M, finds equilibrium at their intersection.

19 RBI holding repo rate at 5.25% in IS–LM terms corresponds to?

Keeping LM fixed while observing IS-side developments.

20 Larger rightward IS shift than LM shift produces equilibrium with?

Higher r and higher Y; IS effect dominates.

21 Which Keynesian motive pairing is incorrect?

Speculative motive determined by productivity of capital; incorrect—actually interest rate.

22 Vertical LM curve at high income + rightward IS shift causes?

Rise in r with no change in Y; complete crowding-out.

23 Bond price–interest rate relationship is mathematically?

Inversely related; higher market rates make fixed coupons less attractive.

24 RBI CRR cut from 3.00% to 2.75% shifts LM rightward, predicting?

Falling deposit rates, rising loan demand, expanding Y—favourable credit growth.

25 Four determinants of interest rate in Hicks–Hansen synthesis are?

Investment-demand, saving function, liquidity preference, quantity of money.

26 Half-sized OMO purchase (₹5,000 cr vs ₹10,000 cr needed) produces equilibrium near?

Approximately 7.5% interest rate, interpolated between 6% and 9%.

27 RBI raises repo rate, LM shifts left, unchanged IS produces?

Higher r and lower Y.

28 Most significant theoretical contribution of Hicks–Hansen IS–LM?

Demonstrated r and Y are simultaneously determined, neither exogenous to other.

29 EBLR-linked home loan moves mechanically with repo rate demonstrates?

Interest rate is fundamentally monetary phenomenon; money market changes transmit directly.

30 Higher nominal income shifts LP curve how?

Outward/rightward; transactions and precautionary demand increase at every interest rate.

31 At r=6%, money wanted ₹50,000 cr but supply ₹40,000 cr causes?

Shortage of ₹10,000 cr; public sells bonds, bond prices fall, r rises to 9%.

32 Keynes' money demand includes which three motives?

Transactions, precautionary, speculative; both income and interest rate dependent.

33 Classical S=I theory determines which IS–LM component?

IS curve; locus of Y and r where intended saving equals intended investment.

34 Keynes' liquidity preference theory determines which IS–LM component?

LM curve; locus of Y and r where demand for money equals supply.

35 On vertical LM (fixed M), what happens to Y when IS shifts right?

Y cannot rise; only r rises. Complete crowding-out of private investment occurs.

36 What is the mathematical relationship between bond price and market yield?

Bond price = PV of fixed cash flows at market discount rate. Price and yield move inversely.

37 How does CRR cut affect equilibrium r and Y?

CRR cut raises M → LM shifts right → r falls and Y rises. Credit growth improves.

38 Name the four Hicks-Hansen determinants of interest rate.

Investment demand, Saving, Liquidity preference, and Quantity of money.

39 Money supply rises from ₹40,000 to ₹45,000 cr. If L=₹40,000 at 9% and L=₹50,000 at 6%, what is equilibrium r?

Approximately 7.5% by linear interpolation between the two schedule points.

40 Leftward LM shift along downward IS creates what change in r* and Y*?

r* rises and Y* falls. Standard monetary-tightening outcome.

41 What was the Hicks-Hansen breakthrough in macro theory?

Simultaneous determination of r and Y; earlier theories held one variable fixed.

42 How does EBLR transmission demonstrate Keynes' core claim?

Policy-rate changes flow to retail lending rates within days; r is monetary phenomenon.

43 What is the transactions motive for money holding?

Hold cash to finance day-to-day purchases between income receipts; rises with nominal income.

44 What is the precautionary motive for money holding?

Hold cash for unforeseen contingencies (medical, job loss); rises with income.

45 What is the speculative motive for money holding?

Hold cash to exploit expected bond-price changes when yields rise; falls as r rises.

46 When nominal income rises, how does the money demand curve shift?

Entire curve shifts right; more money demanded at every interest rate.

47 At equilibrium r=9%, M=₹40,000 cr. If RBI buys ₹10,000 cr via OMO, what is new r?

6%. New M=₹50,000 cr matches L=₹50,000 cr at 6% from schedule.

48 What market does the IS curve represent?

Commodity (goods) market. Every point satisfies: Intended Saving = Investment.

49 What market does the LM curve represent?

Money market. Every point satisfies: Money Demand = Money Supply.

50 Why does IS curve slope downward?

Higher r reduces investment demand → requires lower Y to equate S=I.

51 Why does LM curve slope upward?

Higher Y raises money demand → requires higher r to clear the money market.

52 Which policy shifts IS rightward and which shifts LM rightward?

Fiscal policy shifts IS; monetary policy (higher M or lower r demand) shifts LM.

53 What does RBI repo rate decision do to LM curve in IS-LM framework?

Keeps LM curve stationary; allows observation of IS evolution with budget changes.

54 What determines interest rate in Classical Theory?

Saving and Investment equilibrium (S = I) in the real sector.

55 What determines interest rate in Keynes' Liquidity Preference Theory?

Money Demand (L) equals Money Supply (M); purely monetary phenomenon.

56 What determines interest rate in Hicks-Hansen IS-LM synthesis?

Joint equilibrium: S=I AND L=M at IS-LM intersection; r and Y simultaneous.

57 Name three components that decompose every quoted interest rate.

Risk premium, Service charge, Pure interest.

58 What are three motives for holding money in Keynes' theory?

Transactions (rises with Y), Precautionary (rises with Y), Speculative (falls with r).

59 How do bond prices and interest rates move in relation?

Inversely: higher r → bond prices fall; lower r → bond prices rise.

60 What is the relationship between transactions demand and income?

Transactions demand rises with nominal income; finances day-to-day payments.

61 Why does speculative demand for money fall when interest rate rises?

Higher opportunity cost of holding cash makes bonds more attractive.

62 What happens to equilibrium interest rate when RBI increases money supply?

Equilibrium rate falls; excess money absorbed only when r drops to raise L.

63 From which theory is the IS curve derived?

Classical S = I framework; NOT from Keynes' Liquidity Preference theory.

64 Why does IS curve slope downward?

Higher income shifts saving rightward, lowers equilibrium r in commodity market.

65 What is the slope of LM curve and why?

Upward: higher Y raises L; with M fixed, r must rise to restore L=M.

66 In IS-LM, are equilibrium r and Y exogenous or endogenous?

Both endogenous; determined simultaneously at IS-LM intersection point E.

67 What is the effect of rightward LM shift from money supply increase?

Equilibrium r falls, Y rises; IS curve unchanged.

68 Does Hicks-Hansen synthesis consider real factors or only monetary factors?

Both: real factors (productivity, thrift) shift IS; monetary factors shift LM.

69 How many assets does Keynes assume in his simplified wealth model?

Two assets: money and long-term bonds; NOT equity shares.

One-linersTheories of Interest