Pure Time Preference Theory

In Context

• The pure time-preference theory of interest is an economic theory that seeks to explain the phenomenon of interest. 

About Pure Time Preference Theory

• American economist Frank Fetter was the best-known proponent of the pure time-preference theory in the 20th century through his 1904 book The Principles of Economics. 
• It states that interest arises when present goods are exchanged for future goods because people, considering all other things being equal, prefer present goods over future goods. 
  • So, for example, an individual may prefer to have ?100 in the present moment over the same ?100 at some time in the future, ceteris paribus. 
  • So, unless an individual expects to receive an amount that is more than ?100 rupees in the future, he would be reluctant to part with the ?100 that is in his possession at the moment.
• Time preference refers to the relative importance that an individual places on the present versus the future. 
  • If an individual prefers immediate consumption over future consumption, he is said to possess high time-preference. 
  • On the other hand, if an individual prefers future consumption over immediate consumption, then he is said to possess low time-preference. 
• A person with low time-preference is likely to save and invest money with an eye on the future while a person with high time-preference may be more likely to spend his money on immediate needs.
• Proponents of the pure time-preference theory of interest disagree with both the productivity theory of interest and the abstinence theory of interest. 
• The pure time-preference theory of interest argues that interest rates are determined purely by the time-preference of lenders alone without any role being played by the productivity of capital. 
• Other theories:
  • There have been various theories that have been proposed throughout history, including the exploitation theory of interest, the productivity theory of interest, and the abstinence theory of interest, to explain why interest is charged when money, or any other good, is loaned out.
    • The productivity theory of interest argues that interest arises because borrowers competing for loans are willing to pay additional money as interest. 
      • The assumption here is that borrowers expect to earn profits by investing the borrowed amount in some productive project and use some of the resulting profits to pay interest. 
    • The abstinence theory of interest, on the other hand, proposes that interest arises because lenders need to be enticed to postpone consumption to the future or they would not be willing to lend their money or goods.  
  • The pure time-preference theory also differs from the simple time-preference theory of interest which states that interest rates are determined by both the time preference of lenders and the productivity of capital. 
  • According to the simple time preference theory, the time-preference of lenders determines the minimum interest rate while competition between borrowers determines the actual interest rate.

Source:TH