Theories of Interest: Why Interest is Paid and Interest Rate Determination

Read this article to learn why interest is paid and different theories of interest!

Different theories have been put forward regarding interest.

These theories can be grouped under two headings:

(a) Theories which explain why interest is paid; and

(b) Theories which explain how the rate of interest is determined.

Let us take these one by one.

Why Interest is paid:

Productivity Theory:

To explain the why of it, one theory put forward is the Productivity Theory, which says interest is paid on capital because capital is productive. The borrower can get additional income from borrowed capital and in easily afford to pay interest. But if capital were free, no interest will be paid u spite of its productivity. Hence it is scarcity rather than productivity which explains interest. Scarcity also explains interest paid for consumption purposes, whereas productivity theory fails to explain it.

Abstinence or Waiting Theory:

Another theory is Abstinence or Waiting Theory. The lender of capital has to be compensated for abstinence or for not immediately using his own capital. He has to do the waiting. But some people will wait and save even if there is no interest. Hence this theory does not explore interest satisfactorily.

Austrian or Agio Theory:

Then there is the Austrian or Agio Theory according to which interest is paid to equate the future satisfaction to the present satisfaction, as it is said that one bird in hand is better than two in the bush.

Time Preference Theory:

Fisher’s Time Preference Theory says that interest is the price for time preference. This time preference depends on the size of a man’s income, the distribution of income over time, the degree of certainty regarding its enjoyment in the future and the temperament and character of the individual.

For example, people with larger incomes will be able to satisfy their present wants more fully and will, therefore, discount future at a lower rate. Thus, the rates of individual time preference, after having been determined in this way, tend to become equal to the rate of interest.

Liquidity Preference Theory:

According to Keynes, who propounded this theory, interest is not a reward for waiting, nor is it a payment for time preference, but it is a reward for parting with liquidity. This theory not only explains why interest is paid; it also explains how the rate of interest is determined.

Theories of Interest-Rate Determination:

As in the case of wages and rent, it is the forces of demand and supply that together determine the rate of interest. But the big question is: demand and supply of what?

There are the following three theories of interest determination which are based on three different answers to the above basic question:

(a) Classical or Real Theory, which explains interest as determined by the demand for and supply of capital.

(b) Loan-able Funds Theory or Neo-classical Theory, which explains interest as determined by demand for and supply of loan-able funds.

(c) Keynes’s Liquidity Preference Theory, which explains that the rate of interest is determined by the demand for and supply of money.