The Determination of Pure Rates of Interest in Underdeveloped Rural Areas

Abstract

T HE determination of interest rates in rural areas throughout the underdeveloped world is best explained in micro-economic terms. The typical village moneylender will either be an outright monopolist, or he will be an imperfect competitor.1 The market for loans will center around the village itself. The farmer will normally only borrow from the one or more moneylenders that the village can support. He will not often have access to a bank or other lending institution. In these circumstances, the moneylender will face a demand curve for his loans which will slope downwards from left to right. The rate of interest will be on the vertical axis and the volume of loans on the horizontal axis.2 He will also have a schedule of costs for lending. This will be compounded of the administration and risk charges on each unit which he lends, together with the opportunity cost of his raw material money. It is this last cost component which corresponds to the pure rate of interest of existing theory. The average cost-of-lending curve will describe the arc familiar to the student of the principles of economics. There will be a certain volume of loans which will maximize the moneylender's net returns. This volume will be at his equilibrium level of lending, and it will determine his most profitable interest charge. It is the opportunity cost of each dollar or rupee which he advances at this equilibrium point which we will analyze here. Questions of average administration and risk charges, as well as of monopoly profit, must be left to other discussions. But it should not be supposed that these are relatively unimportant considerations. Risk and administration costs in particular probably play the major role in forcing high interest rates upon farmers in poor countries.3 If we view the opportunity cost of the lender's money as one of the determinants of his costs, then we could draw a curve representing these charges. It would probably run parallel to the volume of lending axis to begin with and then rise quite sharply as the moneylender adds to his loans. The unit opportunity cost is thus registered on the vertical axis and it forms one of the components of the interest rate which the farmer must ultimately pay. The reasons why the opportunity cost of the money used in a lender's loans will describe such a curve can best be explained under two separate headings. They are: (1) the returns on alternative investments, and (2) liquidity preference.