Time Preference - Neoclassical Views

Neoclassical Views

In neoclassical economics, the rate of time preference is usually taken as a parameter in an individual's utility function which captures the trade off between consumption today and consumption in the future, and is thus exogenous and subjective. It is also the underlying determinant of the real rate of interest. The rate of return on investment is generally seen as return on capital, with the real rate of interest equal to the marginal product of capital at any point in time. Arbitrage, in turn, implies that the return on capital is equalized with the interest rate on financial assets (adjusting for factors such as inflation and risk). Consumers, who are facing a choice between consumption and saving, respond to the difference between the market interest rate and their own subjective rate of time preference ("impatience") and increase or decrease their current consumption according to this difference. This changes the amount of funds available for investment and capital accumulation, as in for example the Ramsey growth model.

In the long run steady state, consumption's share in a person's income is constant, which pins down the rate of interest as equal to the rate of time preference, with the marginal product of capital adjusting to ensure this equality holds. It is important to note that in this view, it is not that people discount the future because they can receive positive interest rates on their savings. Rather, the causality goes in the opposite direction; interest rates must be positive in order to induce impatient individuals to forgo current consumptions in favor of future.