Time-Preference Theory Of Interest

You have $100 in your hand. Life is full of tradeoffs—including this one. Do you spend it? And if so, on what? Or maybe invest it? Give it to your mom? Hmmm.

The time preference theory of interest is the idea that interest is the price of time. If you invested that $100, you would be rewarded (in terms of the interest rate) for waiting to spend it. This is based off the theory that people want to spend their money now. Saving it for later is both a luxury (because you can) as well as a burden (you’d rather spend it on Starbucks frapuccinawhatever, or those designer jeans, or that video game...right now).

This might sound obvious, but there are other theories for interest rates out there that seem to make sense, too. For instance, classical economics sees interest rates as the result of supply and demand for capital. Interest rates help make the supply and demand for capital possible. There’s also the liquidity preference theory, which is the theory not that people want to spend now...but that they generally prefer their money to be liquid, i.e. accessible at a moment’s notice.

The longer you want someone to lend you their money, the more you’ll have to pay them in interest to convince them it’s a good deal.