Time preference theory of interest (1871)

Developed first by Austrian economist CARL MENGER (1840-1921), time preference theory of interest is the analysis of how individuals or firms will sacrifice present utility in the hope of greater future returns. The expected rate of return is highly subjective.

Also see: term structure of interest rates, random walk hypothesis

Source:
C Menger, Principles of Economics, J Dingwall and B Hoselitz, eds (Glencoe, 111., 1950)

In behavioural finance, time preference (or “discounting”) pertains to how large a premium a consumer will place on enjoyment nearer in time over more remote enjoyment.

There is no absolute distinction that separates “high” and “low” time preference, only comparisons with others either individually or in aggregate. Someone with a high time preference is focused substantially on his well-being in the present and the immediate future relative to the average person, while someone with low time preference places more emphasis than average on their well-being in the further future.

Time preferences are captured mathematically in the discount function. The higher the time preference, the higher the discount placed on returns receivable or costs payable in the future.

The time preference that an individual exhibits at any given moment is determined by both their personal preferences and external circumstances. Thus, if one “prefers” to save his money but cannot do so in the present, he is still considered to have a low time preference. One of the factors that may determine an individual’s time preference is how long that individual has lived. An older individual may have a lower time preference (relative to what he had earlier in life) due to a higher income and to the fact that he has had more time to acquire durable commodities (such as a college education or a house).

The time preference theory of interest is an attempt to explain interest through the demand for accelerated satisfaction. This is particularly important in microeconomics.

In the neoclassical theory of interest due to Irving Fisher, the interest rate determines the relative price of present and future consumption. Time preference, in conjunction with relative levels of present and future consumption, determines the marginal rate of substitution between present and future consumption. These two rates must necessarily be equal, and this equilibrium is brought about by the relative prices of present and future consumption.