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

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

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.

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