Theories of Interest

Theories of Interest:

Some of the theories of interest are as follows:

1. The Abstinence or Waiting Theory of Interest;
2. The Agio Theory and Time Preference Theory;
3. The Marginal Productivity Theory;
4. Saving and Investment Theory (i.e., The classical theory)
5. Loanable Funds Theory and
6. The Liquidity Preference Theory

According to the Abstinence theory of Nassau Senior, interest is the prize for abstaining from instant consumption of wealth. Whenever people save, they abstain from current consumption. That includes some sacrifice. To make them save, interest is provided as a reward. However Marshall favored the word, “waiting” to “absitinence”.

The “Agio” theory of interest of Bohm-Bawerk states that as the present carries a premium (i.e., agio) over the future, and as people prefer present to future consumption, we have to pay a price for them by way of compensation; and that is interest. The time preference theory of Irving Fisher is more or less similar as Agio theory of interest. The marginal productivity theory of distribution is nothing however the application of the marginal productivity theory of distribution. It states that interest tends to equivalent the marginal productivity of capital. The classical theory of interest states that the rate of interest is determined by the supply of capital that depends upon savings and the demand for capital for investment. The theory depends on the supposition that there is a direct relationship among the rate of interest, savings and direct relationship among interest and investment. The classical economists believed that savings would augment whenever the interest rates were high, and investment would rise with a fall in interest rate. And the equilibrium among saving and investment was brought around by the rate of interest.

 

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