Marginal Productivity Theory is a theory that states that the marginal productivity of capital determines the rate of interest. The marginal product of capital cannot be independently determined as all the factors jointly produce every product. The theory is one-sided as it stresses only the demand side of capital for the determination of interest. The demand-supply theory is another theory of interest rate. According to this theory, the need for and the amount of capital jointly establish the rate of interest.
The requirement for capital is governed by its marginal product and the quantity of capital by waiting and saving. This theory is often criticized. The abstinence or waiting theory holds the view that interest is the incentive for the abstention from the present expenditure. It means earning interest by abstaining from spending so that the funds are available for borrowers. This theory asserts that money is used for lending purposes.
There are three theories of interest rate determination. The first is the liquidity preference theory. This theory states that investors must be compensated for any risk that occurs from holding longer-term debt securities. The compensation must come in the form of a premium that is either liquidity or yield.
The second theory is the market segmentation theory investors can concentrate their debt in holdings for a certain length of time to mature. An investor can choose to hold a bond for a two to five years, or choose to do so for a longer amount of time. Another is a marginal productivity theory. This theory states that the rate of interest is determined by the marginal productivity of capitol.
According to the liquidity preference theory, investors must be compensated for assuming the risk of holding longer-term debt securities, and this compensation is in the form of a yield or liquidity premium.
according to the market segmentation theory, investors concentrate their debt holdings in a particular term to maturity. for example, an institutional investor may focus its holdings on bonds with terms of two to five years, while another investor may have a preference for long-term bonds.