In: Economics

Theories of Interest in Economics.

What is Productivity Theory of Interest in Economics? Critically illustrate.

What is Waiting Theory of Interest in Economics ? Illustrate it.

What is Time Preference Theory of Interest in Economics ? Illustrate it. 


Expert Solution



This was the theory given by classical economists. According to them, just like land and labour, capital has also got productivity. The borrower of money, through the use of funds, increases the productivity of his other resources and earns profit. Hence, the borrower should pay the capital for its productivity, just as he pays to the land and labour.

Although the above thought appears to be logical, there are some shortcomings also.

Firstly, if interest is a reward of productivity, then it should change as per productivity. If productivity is high, interest rate should be high and when productivity is low, rate of interest should be low. But in reality, it is not so.

Secondly, when money is lent for consumption, rather than for production, then no interest be charged, because productivity of consumption is zero. But, again it is not so. The lender of money wants interest for lending his funds, irrespective of the fact, whether money will be used for consumption or production. Hence, this theory was not considered a very satisfactory explanation of interest.




Nasseau Senior had given this theory as an explanation of the justification of interest. According to him, savings are essential for lending and savings are possible only when one deprives himself from consumption. Only when we abstain from consumption, that we can lend money to others. We will have to wait for sometimes before we can use that money. Interest, according to him, is the reward for waiting. If no reward is given for this waiting, then nobody will be motivated to save and then no capital will be available for lending. Marshal had also supported this viewpoint. 




Bohm Bawerk and Fischer had supported this view point. A human being, according to them, has a natural preference for present over future. He will, therefore, prefer present consumption over future consumption. In other words, we can say, he discounts the future. This time preference can be overcome only if interest is offered as a compensation. Rate of interest, therefore, can be called as the rate which overcomes the time preference for present over future. 

This was the theory given by classical economists. 

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