Time Preference Theory of Interest

By: EconomyWatch   Date: 14 October 2010

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In economics, the Time Preference Theory of Interest is concerned with the relation between increase or decrease in the rate of interest with respect to time periods. According to this theory, the variation in the premium or the interest rate depends totally upon the risk of occurrence of an event.

According to the Time Preference Theory of Interest, there is absolutely no line of demarcation between ‘high’ and ‘low’ time preference, though they allow comparisons with other factors, either separately or collectively. The rate of interest in case of people with high time preference tends to be more, owing to the risk involved in it. In fact, here the premium or the interest rate is more, as it covers a person for lesser time span, where the scope for payment is much more. Contrary, the situation is just the opposite in case of someone having low time preference. The rate of interest and premium paid by them are nominal in nature.

The mathematical implication of the Time Preference Theory of Rate of Interest finds expression in the discount function. It simply means that with the increase in the time preference, the discount rates escalate on the receivable returns or prices to be paid in future.

The time preference displayed by an individual at any given point of time is calculated on the basis of his/her private preferences and external conditions. So, if a person intends or ‘prefers’ and plans for financial savings, but is unable to implement it instantly, he is entitled to have more time preference. The mortality rate of an individual is also an important factor affecting the nature of his/her time preference to large extents. This is precisely why an aged person with lesser time preference is required to pay more premium and interest.

The Time Preference Theory of Interest is a macro-economic concept, explaining interest in terms of the demand for accelerated satisfaction. This is indeed, one of the most important macro-economic theories.



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