Time-Preference Theory of Interest

What Is the Time-Preference Theory of Interest?

The time preference theory of interest, also known as the agio theory of interest or the Austrian theory of interest, explains interest rates in terms of people's preference to spend in the present over the future.

This theory was developed by economist Irving Fisher in "The Theory of Interest, as Determined by Impatience to Spend Income and Opportunity to Invest It." He described interest as the price of time, and "an index of community’s preference for a dollar of present over a dollar of future income."

How the Time-Preference Theory of Interest Works

Other theories, besides the time preference theory of interest, have been developed to explain interest rates. The classical theory explains interest in terms of the supply and demand of capital. Demand for capital is driven by investment and the supply of capital is driven by savings. Interest rates fluctuate, eventually reaching a level at which the supply of capital meets the demand for capital.

Liquidity preference theory, on the other hand, posits that people prefer liquidity and must be induced to give it up. The rate of interest is intended to entice people to give up some liquidity. The longer that they are required to give it up, the higher the interest rate must be. Hence, interest rates on 10-year bonds, for example, are typically higher than on two-year bonds.

Neoclassical Views on the Time-Preference Theory of Interest

Irving Fisher’s neoclassical views on the time-preference theory of interest state that time preference relates to an individual’s utility function, or the extent to which one measures the worth or value of goods, and how that individual weighs the trade-off in utility between present consumption and future consumption. Fisher believes that this is a subjective and exogenous function. Consumers who are choosing between spending and saving respond to the difference between their own subjective sense of impatience to spend, or their subjective rate of time preference, and the market interest rate, and adjust their spending and saving behaviors accordingly.

According to Fisher, subjective rate of time preference depends on an individual’s values and situation; a low-income person may have a greater time preference, preferring to spend now since they know that future needs will make saving difficult; meanwhile, a spendthrift may have a lower time preference, preferring to save now since there is less concern about future needs.

Austrian Thinkers on the Time-Preference Theory of Interest

Austrian economist Eugen von Böhm-Bawerk, who expounded on the theory in his book Capital and Interest, believes that the value of goods decreases as the length of time needed for their completion increases, even when their quantity, quality, and nature remain the same. Böhm-Bawerk names three reasons for the inherent difference in value between present and future goods: the tendency, in a healthy economy, for the supply of goods to grow over time; the tendency of consumers to underestimate their future needs; and the preference of entrepreneurs to initiate production with materials presently available, rather than waiting for future goods to appear.