Theories of Interest
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Theories of Interest

Theories of Interest Different theories have been put forward regarding interest. These theories can be grouped under two headings: (i) There are theories which explain why interest is paid; and (ii) Theories which explain how the rate of interest is determined.

Theories of Interest

Different theories have been put forward regarding interest. These theories can be grouped under two headings:

(i) There are theories which explain why interest is paid; and

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

Why Interest is Paid

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

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.

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

Fisher's Time Preference Theory says that interest is the price for time preference. This time preference depends on the amount of a man's income, the allocation of income over time, the extent of confidence regarding its enjoyment in the future and the nature and temperament of the human being. 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 inclination, once having been confirmed in this method, are likely to develop into equivalent to the rate of interest;

Keynes's Liquidity Preference Theory also explains why interest is paid. This theory also explains how rate of interest is determined.

Among the theories under this category may be mentioned (a) classical or real theory, which explains interest by productivity from the demand side and thrift from the supply side: (b) Loanable Fund Theory or Neo- Classical Theory, which explains interest as determined by demand for and supply of loanable funds, and (c) Keynes’s Liquidity Preference Theory or The Keynesian Theory of Interest or the Monetary Theory of Interest.

All these three theories of Interest seeks to explain the determination of the rate of interest through the equilibrium between the forces of demand and supply, but the big difference among these theories lies in the answer to the question: demand for what and supply of what?

 

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