If your familiar with my website or blog, or have seen any of my videos you know that I love to talk economics so now that I’ve joined the Objects in Motion team I plan on doing the same. So this will be my first in what I hope to be many posts on economics, please e-mail me your questions for me to answer in future posts to alexmerced@alexmerced.com.
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So today we ask the question, what are interest rates?
Before we can understand interest, we must understand that not everyone can consume at the same time because there is only so many resources for people to consume now. So the problem becomes how do we decide who gets to consume now versus later?
Let’s examine four different people…
Person A wants to consume now and has the resources he needs to consume now because he either earned the resources from current labor/production or saved it from previous labor/production, so he is able to consume now and does so.
Person B doesn’t want to consume and doesn’t have the resources to do so. Instead he’ll use his time for leisure or to labor/produce to have resources for consumption later.
Person C wants to consume but doesn’t have the resources to do so since he hasn’t saved, or hasn’t saved enough for the desired amount of consumption.
Person D has plenty of resources to consume now but may consume later.
… So Person C could possibly could consume now since Person D isn’t sure if he wants to consume now, so if Person C can just convince Person D to delay consumption then Person C can borrow those resources and consume now.
Austrian Time Preference Theory states that a good today is more valuable than a good tomorrow. For example if I said you can buy one of two apples for $5, an apple you can eat today or an apple you can eat 5 years from now you’d choose the apple you can eat today. Being an identical good, the instant gratification of the apple today has a value premium over an apple 5 years from now. If I changed the price to $5 for the apple of today and then $3 for the apple in 5 years then you might choose to purchase the future apple. Another example is how pre-sale tickets to a movie or concert are cheaper than buying them at the actual event. It’s cheaper before the show cause at that time it’s a future good so they mark it down to make more valuable over present goods, as time passes it becomes a present good and increases in value to the door price.
So return back to Person C and Person D, if Person C said he’d borrow %100 of Person D’s resources today and give him back 100% sometime in the future, Time Preference Theory would suggest there is no value in this exchange for Person D, so he wouldn’t delay his consumption cause it’d be the more valued option in this case.
What if… Person C said he’ll borrow 100% of Person D’s resources today and paid back 110% of them in the future, Person D would have 10% more to consume sometime in the future if he delayed the consumption of the 100% now. That is interest, the price that someone pays for someone else to delay consumption. In this case the rate of interest was 10% (the amount paid above the original 100%). How would normal market forces determine this interest rate?
Well if Person D had so much resources that he can’t find enough people to lend it all too, then he’d have to lower the price/interest to increase demand to meet his large supply of resources. So the more people save/delay consumption the more resources that loanable exist and the large supply would push down the price to borrow it.
What if Person D had very little resources and lot of people wanted to borrow it, well then he’d raise the price/interest to lower the demand to be in line with his supply of loanable resources. So when people decide to consume now and don’t save the supply is low so interest rates much rise.
So this is the basics about interest rates, in my next post I’ll discuss the effect of interest rates in the worlds of Investment and Production.
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