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Time Preference Theory

 Time Preference Theory

            The time preference theory is associated with Irving fisher who defined interest as an “index of community’s preference for a dollar of present over a dollar of future income.” Time preference is the preference that people have for present income over future income of an equal amount and equal certainty. It is a tendency on the part of the people to vary the income meant for consumption from time to time by saving and borrowing.

            Interest is the price that is paid to the people for present income rather than for future income. It is determined by the willingness principle and the investment opportunity principle.

  1. Impatience or Willingness Principle

    It depends upon size of income, distribution of income, composition of income, certainty of enjoying income in future, personal traits of individuals such as foresight, self restraint in consumption etc. I the income size is large, individuals will satisfy present wants more and discount the future at a lower rate.

    The distribution of income may take place in three different ways: first income may be uniform throughout, second, it may decrease in future and third it may increase gradually in the future. If the income is uniform throughout the rate of impatience will be determined by the dimension of income and foresight.

    If income increases as a person advances in age, the present income will be less and the rate of impatience will be high and vice versa. The behaviour or composition of income is also similar.

    So far, as the certainty of enjoying future income is concerned if the future is uncertain the rate of impatience will be high and vice versa. When the rate of willingness is determined in this way, it tends to equal the rate of interest. If it is higher than the market rate of interest, an individual will borrow and use this amount to satisfy his more pressing wants.

    Alternatively, if the rate of willingness is lower than the market rate of interest he will lend his income and gain thereby. He will continue to change his income by borrowing or lending, till the rate of willingness equals the market rate of interest.

  1. Investment Opportunity Principle

    The rate of return over cost depends upon the extent to which an income stream might be shifted by changes in capital utilisation. If the individual has two investment opportunities before him in the form of two income streams that can be substituted for each other, ‘cost’ implies the loss of withdrawing one income stream and ‘return’ is the gain from substituting one income stream for another.

    The rate of return over cost is that discount rate at which the present net values of the two investment opportunities are equalised. The ranking of investment opportunities, according to Fisher depends on the rate of interest. An investment opportunity may have a higher present value at a particular interest rate than at another.

    So is the rate of return over cost in case of one opportunity is higher than the market rate of interest, it will be accepted and the other opportunity will be discarded.

Criticisms

  1. Neglects Banking System

    Fisher’s theory is very general and fails to show the influence of the banking system on the rate of interest.

  1. Emphasis on Consumption

    The willingness principle is misleading for the reason that it lays too much prominence on consumption of earnings.

  1. Silent about Expectations

    This thesis is silent about the impact of expectations on interest rates. Even if interest rates are upward moving, expectations of high future returns can encourage investment.

  1. Too much Prominence on Capitalisation

    Fisher has been criticised for laying too much prominence on capitalisation. There may be divergences amidst capitalised rates in the rental markets and resale markets. For instance, rental returns on properties in poor regions might have values at capitalised rates but in the open markets their capitalised rates would be much lower.

  1. Neglects Demand Side

    It considers the factor supply side while determining the rate of interest and absolutely neglects the demand side altogether.

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