Time-Preference Theory Of Interest

The time preference theory of interest explains interest rates in terms of people's preference to spend in the present over the future. This theory was developed by economist Irving Fisher in "The Theory of Interest, as Determined by Impatience to Spend Income and Opportunity to Invest It." He described interest as the price of time, and "an index of community’s preference for a dollar of present over a dollar of future income."

Other theories, besides the time preference theory of interest, have been developed to explain interest rates. The classical theory explains interest in terms of the supply and demand of capital. Demand for capital is driven by investment and the supply of capital is driven by savings. Interest rates fluctuate, eventually reaching a level at which the supply of capital meets the demand for capital.

Liquidity preference theory, on the other hand, posits that people prefer liquidity and must be induced to give it up. The rate of interest is intended to entice people to give up some liquidity. The longer that they are required to give it up, the higher the interest rate must be. Hence, interest rates on 10-year bonds, for example, are typically higher than on two-year bonds.