The
interest rate links the future to the present. It allows individuals to
evaluate the value
today-the present value-of future income and costs. In essence, it is the
market price
of earlier availability. From the
viewpoint of a potential borrower, the interest rate is the premium that must be paid in order to acquire
goods sooner and pay for them later.From the lender’s viewpoint, it is a reward for
waiting-a payment for supplying others with current purchasing power. The interest rate
allows the lender to calculate the future benefit (future payments earned) of extending a loan
or saving funds today.
In a modern economy, people often borrow funds to finance
current investments and consumption. Because of this, the interest rate is
often defined as the price of loanable funds. This definition is correct. But
we should remember that it is the earlier availability of goods and services
purchased, not the money itself, that is desired by the borrower.
How interest rates determined
Interest rates are determined by the demand for and
supply of loanable funds. Investors demand funds in order to finance capital assets they
believe will increase output and generate profit. Simultaneously, consumers demand loanable
funds because they have a positive rate of time preference: they prefer earlier
availability.The demand of investors for loanable funds stems from
the productivity of capital. Investors are willing to borrow in order to finance the use of
capital in production because they expect that expanding future output will provide
them with more than enough resources to repay the amount borrowed-the principal-and
interest on the loan. Our prior example of Robinson Crusoe illustrates this point.
Remember, Crusoe could increase his output by 200 fish this year if he could take off
fifty-five days from hand-fishing to build a net. But doing so
would reduce Crusoe’s fish production by 2 fish per day
while he was constructing the net. Suppose a fishing crew
from a neighboring
island visited Crusoe and offered to lend him 110 fish so he could undertake the
capital investment project (building the net). If Crusoe could borrow the 110 fish (the
principal) in exchange for, say, 165 fish one year later (1 10 fish to repay the principal and
55 as interest on the loan), the investment project would be highly profitable. Crusoe could repay
the funds borrowed, plus the50 percent interest rate, and still have 145
additional fish (the 200 additional fish caught minus the 55 fish paid in interest).Crusoe’s demand for loanable fish-and, more generally,
the demand of investors for loanable funds-stems directly from the productivity of
the capital investment. Crusoe can gain by borrowing to finance the construction of a
fishing net only because the net enables him to expand his total output during the year.
Similarly, investors can gain by borrowing funds to undertake investment projects only when the
capital assets they purchase permit them to expand output (or reduce costs) by enough to
make the interest payments and still have more output than they would have without the
investment.The interest rate brings the choices of investors
and consumers wanting to borrow funds into harmony with the choices
of lenders willing to supply funds. Higher interest rates make it more costly for
investors to undertake capital spending projects and for consumers to buy now rather
than later. Both investors and consumers will therefore curtail their borrowing as the interest
rate rises. Investors will borrowless because some investment projects that would be
profitable at a low interest rate will be unprofitable at higher rates. Some
consumers will reduce their current consumption rather than pay the high interest premium when the
interest rate increases. Therefore,the amount of funds demanded by borrowers is inversely
related to the interest rate.The interest rate also rewards people (lenders)
willing to reduce their current consumption in order to provide loanable funds to others. If some
people are going to borrow in order to undertake an investment project (or
consume more than their current income),others must curtail their current consumption by an
equal amount. In essence, the interest rate provides lenders with the incentive to reduce
their current consumption so that borrowers can either invest or consume beyond their current
income. Higher interest rates give people who are willing to save (willing to supply
loanable funds) the ability to purchase more goods in the future in exchange for sacrificing
current consumption. Even though people have a positive rate of time preference,
they will give up current consumption to supply funds to the loanable funds market if the
price is right. Higher interest rates will induce people to save more. Therefore, as the
interest rate rises, the quantity of funds supplied to the loanable funds market will increase.money rate versus real rate of interest
We have emphasized that the interest rate is a premium
paid by borrowers for earlier availability and a reward received by lenders for delaying
consumption. However, during a period of inflation-a general increase in prices-the nominal
interest rate, or money rate of interest, is
a misleading indicator of how much borrowers are paying and lenders are receiving. Inflation reduces the purchasing power of a
loan’s principal. Rising prices mean that when the borrower repays the principal in the
future, the repayment amount will not purchase as much as it would have when the funds were
initially loaned. When inflation is common, lenders will recognize that
they are being repaid with dollars of less purchasing power. Unless they are compensated
for the anticipated inflation byan upward adjustment in the interest rate, they will
supply fewer funds to the loanable funds market. At the same time, when borrowers
anticipate inflation, they will want to purchase goods and services now before they become even more
expensive in the future.Thus, they are willing to pay an inflationary premium, an additional amount of interest that reflects the expected rate of future price
increases. For example, if borrowers and lenders fully anticipate a 5 percent rate
of inflation, they will be just as willing to agree on a 9 percent interest rate as they were earlier to
agree on a 4 percent interest rate when both anticipated price stability. Unlike when the general price level is stable, the
supply of loanable funds will decline (the supply curve will shift to the left) and the
demand will increase (the demand curve will shift to the right) once decision makers
anticipate future inflation. The money interest rate thus rises, overstating the “true” cost of
borrowing and the yield from lending. This true cost is the real rate of interest, which
is equal to the money rate of interest minus the inflationary premium. It reflects the real burden to
borrowers and payoff to lenders in terms of their being able to buy goods and services. Our analysis indicates that high rates of inflation
will raise the money rate of interest. The real world is consistent with this view. Money
interest rates rose to historical highs in the United States as inflation soared to double-digit
rates during the 1970s. These same nominal rates fell to the 5 percent
range as inflation fell below 2 percent in the 1990s.
Cross-country comparisons also illustrate the link
between inflation and high interestrates. The lowest money interest rates in the 1990s
and early 2000s were found in nations such as Germany, Switzerland, and Japan, all with low
rates of inflation. In contrast, the highest money interest rates were observed in Russia,
Brazil, Turkey, and other countries with high rates of inflation
during the period.
loan 
(0 vote)