Different Theories Of Interest In Economics

Different Theories of Interest Rate Determination

a) Productive theory of interest : Productive theory explains that interest is paid because capital is productive. Capital helps laborers to produce more output of goods. Hence a borrower must pay something to the lender as he is enabled to produce more.

Criticism of Productive theory of interest rate determination :

1. This theory explains why interest should be paid. But it does not explain how rates of interest is determined.
2. This theory explains that interest is paid for the productivity of capital. But it does not explain why interest is paid on money taken for consumption purpose.
3. This theory does not explain the reasons for different rates of interest exist in the money market.

b) Abstinence or Waiting Theory of Interest : The abstinence theory of interest has been sated by Prof. Senior. According to him, interest is the reward for abstinence. For the creation of capital goods, people must save. Saving involves sacrifice of present consumption goods. That means they are abstaining from present consumption Such abstinence is disagreeable and some compensation must be paid to the people for undergoing the sacrifice. The payment of such compensation is interest. Thus, this theory tells that interest is a reward for abstinence. This idea of abstinence was criticized on the ground that saving is created by mostly rich people. Rich people do not feel any inconvenience. They do not postpone their present consumption. Therefore to avoid this drawback Marshall substituted the term “waiting for abstinence. According to Marshall, the people who postpone their present consumption will wait for a certain time only. They did not abstain from consumption permanently. Generally as people do not like to wait for more time some amount of reward should be paid for them. Therefore, according to Marshall interest is a reward for the waiting of the saver.

c) Agio or Austrian Theory : The Agio theory of interest is stated by the Austrian economist Bohm Bawerk. This is also called psychological theory of interest. This theory tells that many people prefer present consumption over future consumption as future is uncertain. So present consumption of goods is preferable to future consumption of goods. The present wants appear to be more important than future wants. Thus, the future undergoes a discount and the discount is the interest. Interest is paid in order to induce people to postpone their present consumption.

The preference for present consumption is due to three reasons:

1. Present wants are felt more important than the future wants.

2. Present goods possess a technical superiority over future goods.

3 The future is uncertain than the present.

d) Time Preference Theory : Irving Fisher formulated the time preference theory of interest. Fisher criticizes the Agio theory of interest and stated his own theory. According to him, man prefers present consumption to future consumption. Man is more impatient to spend his income on the satisfaction of his present wants. He is eager to spend his income as early as possible. To overcome this, preference for the present interest must be paid. Interest is the price of time. If a man is offered the choice of $200/- now, or a similar payment after one year, he could invariably choose immediate payment. But if he is offered $250/- he might choose the future payment. This extra amount of $50/- measures the time preference.

The time preference depends upon the following factors:

1.Size of Income : If the income is less, the time preference will be higher and vice-versa.

2. Distribution of Income When income is expected to rise in future time, preference will be less and vice-versa.

3. Character of the Individual : If the individual is spend-thrift time preference will be higher. If the individual is a miser, the time preference will be less.

4. Certainty of income in the future: If a person is certain of recovering income in the future,  his impatience to spend will be high in the present.

Thus, interest is the rate at which future satisfaction is discounted in the present. It is a payment which equates the future values With the present values.

Criticism of Time Preference Theory interest:

1. Like other earlier theories, the theory is also incomplete. It analyses the problem of interest determination for the supply side alone, neglecting the demand side altogether.

2. The time preference of the people differs from person to person. The theory does not tell us clearly as to whose time preference determines the rate of interest in the country.

3. Time preference is a psychological element. Hence, it is not possible to measure it accurately.

4. The theory does not explain the influence of the banking system on the rate of interest.

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