Interest

The third factor production is capital which is man-made. After defining rent as the payment made for the use of land and wages as the price paid for the use of labour, it seems appropriate to define interest as the payment made for the use of capital. But there are two concepts of capital- physical capital and financial (money) capital. Accordingly, there are two concepts of interest-real rate of interest and money rate of interest.

Real rate of interest is the rate of return on physical capital such as a machine or a tractor created for the purpose of producing more goods. Money rate of interest is the price paid for the use of barrowed funds. The borrowed funds are mainly used for investment physical capital. But these funds may also be used for investment in land, acquiring consumption goods or even spent in paying wages. Again the return obtained from the investment of funds in fixed capital goods may be larger or smaller than the rate of interest paid on borrowed funds. Which of these two-return on capital goods or interest paid on borrowed funds. Which of these two-return on capital goods or interest paid on borrowed funds-would be called the payment made for the use of capital goods? Here the answer cannot be definite if we define interest as the price of capital.