Theories of Interest Rate Determination - 1 | Economics Optional Notes for UPSC PDF Download

Productivity Theory of Interest

According to this theory interest arises on account of the productivity of capital.

• The amount that labour produces with the help of capital goods is generally larger than the amount it can produce when working by itself. Machinery and tools invariably add to the income of those that use them. That is why they are demanded by individual employers.
• Further some classical economists hold that Interest is the reward paid to capital because it is productive. In fact, Interest is paid out of the productivity of capital. When more amount of capital is employed along with labour and other resources, the over-all productivity improves.
• By employing capital the borrower (entrepreneur) obtains higher production, he ought to pay a part of this additional production to the owner of capital in the form of Interest. The theory implies that capital is demanded because it is productive. And, because is productive its price, i.e., Interest must be paid.

Criticisms

The important criticisms of this theory are as follows:

• This theory is one sided: Economists have called this theory as one-sided. It is half-truth, because it is related only to the demand aspect of capital and it completely ignores the supply side. If, however, the supply of capital is abundant, then, however great the capital productivity may be, the question of Interest will not arise, or at-least, Interest will be only normal.
• Considers only the higher productivity of capital: Next, this theory suggests that when productivity of capital is higher, Interest is payable. On the contrary if capital is in short supply, greater will be the relative scarcity and higher will be the rate of Interest.
• Productivity of Capital Varies: Again, productivity of capital varies in different industries and in different trades. This means that Interest rates should differ from industry to industry. However, the fact is that the pure Interest rate will be the same throughout the market and the borrower may borrow capital for any use.
• Difficult to measure the exact productivity: It is difficult to measure the exact productivity of capital, as capital cannot produce anything without the help of labour and other factors.
• How much interest for consumption loans? This theory fails to explain the Interest paid for consumption loans. Because in practice we find that interest-bearing loans are also made for consumption purposes.

Abstinence or Waiting Theory of Interest

• This theory was expounded in 18th century by an eminent economist N. W. Senior. According to him, “Capital is the result of Saving”. He was the first economist to point-out that saving, which was later on embodied in capital goods, involved a sacrifice, an „abstinence‟ as he called it.
• People may spend the whole of their income in consuming present goods. But when they save they „abstain‟ from present consumption. Such abstinence is disagreeable. Hence, in order to induce people to save, we must offer them some inducement as compensation for their sacrifice. Interest is therefore the compensation for abstinence.
• Marshall substituted the word „waiting‟ for abstinence. Saving connotes waiting, when an individual saves a part of his income, he does not thereby eternally refrain from consumption. He only defers his consumption for a certain period, i.e., till the fruits of his savings come in an increasing flow afterwards.
• Meanwhile he must wait, and as a rule people do not like to wait. Not only saving, but all kinds of productive activity involve waiting. A farmer who sows his crops must wait till crops are harvested. The gardener who plants a seed must wait till it grows into a tree and begins yielding fruit.
• Waiting is, therefore, a necessary condition for production. It is thus a separate factor of production and can be substituted for other factors. Since waiting is a factor of production, its price will be determined by the marginal analysis. That is, the rate of interest tends to equal the reward necessary to call forth marginal increment of saving.

Criticisms

This theory has been criticised on the following grounds:

• This theory takes no consideration of the productivity of capital: In fact, here the borrower uses and pays for the capital because it is productive.
• In this sacrifice cannot be measured: In this theory the feeling of sacrifice or real cost of saving cannot be measured so it is difficult to see how a given rate of Interest can be arrived at by this theory. This theory is subjective and not amenable in practice.
• In this rich hardly experience any inconvenience as they have enough money: As we have experienced that a large part of capital comes from rich, wealthy lenders who have a surplus of income so that they hardly experience any inconvenience or sacrifice of consumption and they save because they do not know what to do with their fabulous income. So mere sacrifice is no justification for the payment of Interest.
• The intensity of feeling of sacrifice is also different for different individuals: It has been seen that many times, a person with small means gets pleasure in saving, where as an extravagant, rich person may feel a great loss of pleasure if he has to save. In answer to this criticism, Marshall has suggested the term „waiting‟ to replace „abstinence‟ in his theory which implies that a person gets Interest as a reward for waiting i.e., by giving loans he passes on his resources and thereby postpones his consumption for the time being, and this has to be compensated. But Cannan was not in favour of the term „waiting‟. In his opinion 'waiting' means inaction and inaction would never produce anything in real life.
• This theory has been called one-sided: Because it emphasises only the supply side, ignoring the factors leading to the demand for saving or capital. Thus, Interest can be paid as a reward to abstain from consumption and save resources for capital formation. Perhaps, this is also true for certain backward modern economies.

The Austrian or Agio Theory of Interest or Bohm-Bawerk’s “The Time- Preference Theory”

• John Rae expounded this theory in the year 1834. Further, Bohm Bawerk developed this theory in an elaborate way. Bohm-Bawerk, an Austrian economist, is the main exponent of this theory which seeks to explain Interest on the basis of time-preference.
• According to this theory, Interest is the price of time of reward for agio, i.e., time preference. It has been argued that man generally prefers present income to a future income and consumption. There is an „agio‟ or premium on present consumption as compared to a future one.
• People prefer enjoyment of present goods to future goods because future satisfaction, when viewed from the present, undergoes a discount. Interest is this discount, which must be paid in order to induce people to lend money and thereby to postpone present satisfaction to a future date. Thus, Interest is the reward made for inducing people to change their time-preference from the present to the future.

According to Bohm-Bawerk, the positive time-preference of people may be attributed to the following reasons:

• As compared to the future or remote wants, present wants are more intenselyfelt by the people.
• Future wants are often under-estimated by people on account of various factors like lack of will power to resist temptation, deficiency of imagination, uncertainty about future as to whether they will be able to enjoy etc.
• Present goods seem to have a technical superiority over future goods in a capitalist method of production because the present goods can be invested and re-invested immediately. Because of the higher productivity of capital, thus, more goods can be accrued in the immediate future while the future goods can be invested and re-invested in the remote future only.

Prof. Fisher’s Time Preference Theory

• Prof. Fisher‟s Time Preference Theory is the modified theory of Bohm-Bawerk. This theory is based on Bohm-Bawerk‟s theory of Interest. While explaining this theory Prof. Fisher has said that—Time preference theory stresses the idea that the supply of loans depends on the fact that most people prefer to have a certain sum of money now than at some future time.
• People normally put a lower valuation on future goods than on present goods. Because of their time preference (i.e., preference for the present than the future) people are eager to spend their income on present consumption. Therefore, when somebody lends to someone, he has to forgo his present consumption.
• He can be made prepared to leave his present consumption only when he is offered some sort of reward. This reward is Interest. Higher, the eagerness to spend on present consumption, higher will be the Interest rate. Thus, Interest rate depends on time-preference or an eagerness to spend income on present consumption.
• In fact Fisher has defined Interest as “an index of the community‟s preference for a dollar of present over a dollar of future income.” As he has said that the intensity of the people‟s preference for present income depends on a host of subjective and objective factors.

These have been grouped under:

(i) Willingness, and
(ii) Opportunity.

Thus, Fisher based his theory of Interest on two principles, viz.:

• the impatience or the willingness principles, and
• the investment opportunity principle.

He laid down that Interest is determined by the preference of the people for the present income against future income, which in turn is determined by the willingness principle and the investment opportunity principle.

(a) Impatience or the willingness principles: This depends on several factors, such as:

• Size of income,
• Composition of income,
• Distribution of income,
• Uncertainty element in the future earnings,
• Personal attributes like foresight, precaution etc.

Some of these factors encourage people‟s patience, some make them impatience. Say, for example, when income is enough, people will be satisfied more of current wants and discounting the future at a lower rate. If uncertainty of future is highly estimated, the rate of impatience will tend to be high.

When the rate of willingness is lower than the market rate of Interest a person will be willing to his income and wish to gain in future. But, if the market rate of Interest is lower than the rate of willingness, the person would like to borrow money and spend it on current consumption.

(b) The investment opportunity principle:

• This principle is another determinant of the rate of Interest. This principle refers to the rate of return over cost, viewed in a specific sense. To explain this phenomenon, let us assume that an individual is confronted with alternative investment proposals which imply two income streams that are substitutes.
• Hence, when he withdraws one income stream to substitute it for another, the loss experienced in the with-drawl is the „cost‟, while the gain accruing from the adopted new income stream is the „return‟.
• The rate of return over cost is, therefore, the rate of discount, which equalizes thepresent net values of the investment opportunities. The rankings of different investment proposals are decided in relation to the rate of Interest.
• If the discount rate is higher than the market rate of Interest, one of the two alternative proposals will be given up. The investment opportunity which carries a higher rate of return over cost will be accepted and the one which has a lower return will be rejected.
• In short, it can be said that the rate of willingness and the rate of marginal return over cost, together determine the people‟s preference for present income rather than future income, which in turn, determines the Interest rate, because Interest is the price paid for this preference. Fisher‟s Theory, in this way considers timepreference as the sole significant determinant of the supply of capital and the rate of Interest.

Criticisms

This Time Preference Theory of Fisher has been severely criticised by many eminent economists.

The important criticisms are as follows:

• This theory is one sided: Modern economists call this theory as one-sided. It explains why capital has a supply price, but it fails to explain why capital has a demand. It completely ignores the productivity aspect of capital.
• This theory fails to recognise the input of bank credit: It considers and explains the supply of capital as the outcome of savings alone. It does not recognise the impact of the banking system and credit creation by commercial banks on investments and the rate of Interest.
• Here time-preference has little practical significance: Economists like Erich Roll and others have stated that the very existence of time preference is questionable and even if it exists, it is very difficult to see any precise significance of time-preference on the determination of Interest.
• This theory has been called as “Incorrect Visualization”: To some critics, it is not proper or it is incorrect to say that a person always prefers present consumption to the future one so that he always insist on apremium to be paid for postponement. On the contrary, strangely enough, very often a person is found to have realised greater satisfaction from future consumption than the present one. Therefore, with these arguments, economists do not call this theory as a correct principle of Interest determination.