Question

Suppose that time preference becomes higher, draw a graph which depicts the change in the (long run) equilibrium interest rate. Explain which curve shifts and why.

Answer 1

Time-Preference Theory of Interest

The time preference theory of interest, also familiar as the agio theory of interest or the Austrian theory of interest, describes interest rates in terms of people's choices to spend in the present over the future. This theory was developed by economist Irving Fisher.
Time preference is the perception that people prefer ‘present goods’ to ‘future goods’ , and that the social rate of time preference, the outcome of the interactions of individual time preference schedules, will decide and be equal to the pure rate of interest in a society. The economy is extended by a time market for present as against future goods, not only in the market for loans, but also as a ‘natural rate’ in all processes of production. Long-run profit rates and rates of return on capital are therefore creates of interest rate. As businessmen want to gain profits and avoid losses, the economy will lean toward a general equilibrium, in which all interest rates and rates of return will be equal, and so there will be no pure profits or losses.