Time Preference TheoryThe Study of Economics is really a study about how humans organise their surrounding environment to achieve a goal, or an end. A very important aspect of this organizing factor is how we think of time.
It is not only curious but necessary to understand that the human condition has both a nonlinear-arrow-like aspect and a circular-cyclical aspect with regards to time.
We are born, we grow old, have children and slowly meet our end. This is the nonlinear-arrow-like aspect.
We also need to eat and sleep every day. This is the circular-cyclical aspect.
As such our ends can never be met entirely with one action. You may only need to search for your wife once in life but you will need to satisfy her daily :-)
We are doomed to repeat. The need to find food, maintain homes, etc. is endless.
The timing of an action & the value of an action has a different value depending on 'when' that action takes place.
So for example, studying before an exam is more valuable than doing the same thing after the exam.
We assume we can take the same action at different times and get a different value.
Time Preference - is very different.
What it says is if I get the same value for an action no matter when I get it.
Would I prefer it sooner, rather than later?
For example, you want to see the Grand Canyon. In terms of the wonder it is, would the joy you take in seeing it change if it was today or 10 years from now?
If that is the case do you prefer to see it now or in ten years?
For the geeks, Time value is called the temporal dimension of action and Time preference is call the intertemporal dimension of action.
Time Value is super important for Traders in the Financial Markets, for taking forward contracts and shorting stocks for example. In this case it is reasonable to assume that people will take actions when it is the most valuable to them (to the best of their knowledge).
Marginal UtilityNow it is also true that having lots of cake may be nice, but having too much cake is not so nice. This is called marginal utility, and it makes sense that we also have a preference for arranging things such that we choose to take value of actions spaced in time.
Intertemporal ActionIs very simply, "I would prefer it now, rather than later" - this is not about being impatient.
It is in the same sense is I prefer a Brick house to a Paper House. It is a preference by logical necessity.
What we are trying to argue here is in the same way that a Brick House is always preferable to a Paper House.
We prefer to receive actions of value sooner, rather than later, always, except for items of marginal utility of course.
Time and InterestInterest is the mechanism by which we try to capture (or model) the effects of Time Preference.
Money by definition is a good that gives you the "same value" regardless of time or location. That's what makes money, money. (barring inflation of course)
So we prefer, Money now, rather than later generally, as it is of value.
This preference is measured as "Interest".
However, there is a hidden dynamic here. Our circumstances are not all equal. There are always going to be people with a greater preference for money now, and people with a lesser preference for the same money now. There are endless reasons why this may be true.
For example, Jim is old and has savings. He is too old to work. He has too much money for his immediate needs and can spend his money over the next 20 years in retirement.
Bob, is young and poor but has a great idea for an Internet dating service. He needs capital to start his business.
These two guys are the beginnings of what we call the 'credit market'.
Jim still prefers to keep his money. Keep it safe for his future. But Bob could convince him to part with some of it for an Interest.
So why would Jim part with the money that he has to help Bob on his venture? Well perhaps the saving that he has are really not that handsome. He can't afford to buy his granddaughter a birthday present, or go on the odd holiday. The little extra cash would do.
The same goes for Bob. He could work flipping burgers his whole life. Then he wouldn't need capital, but his ambitions for a better life motivate him to start a new business.
This is all driven by the underlying human need (especially for young adults) to date. They are willing to use Bob's service and part with some of their money for the chance of a better date.
So the underlying forces here that create the condition in which Interest forms, is the underlying human condition.
It is the amalgamation of all humans everywhere that creates the need for interest and the credit markets.
As such, I find it odd why we need any kind of central bank to 'set' the interest rate. The leading argument seems to me that people don't believe markets would be stable without the safety factor of central banks.
Side Note on MarxismThe Marxists, which I will use as a shortcut to mean all theories that tend to the political left, postulate that Interest is actually explained by the excess or surplus value of labour extracted by greedy capitalists.
But profits can actually be explained better by the Time preference of Money. Labour is normally paid in advance of receiving money from clients. That is, the capitalist takes risk (delayed payment) on all invested moneys. This payment in advance is discounted at an interest which is why the labour is paid less than what seems obvious.
I will dive into the The Labour Theory of Value in another article.