Interest rates, Intermediate Macro
The interest rate is a price unlike any other. It is the price of money today in terms of money tomorrow. The supply curve for the interest rate consists of people willing to lend out money at various interest rates. The demand curve is how much money people want to borrow at various interest rates. When the interest rate is high, the cost of borrowing is high, and demand is relatively low, but supply is high. When the interest rate is low, the quantity of loans demanded is high, but since the return from lending is low, fewer people are willing to supply loans.
Demand for loans comes from two main sources: productive investments and subjective time preference. "Productive investments" means that people can use money today to buy capital, which increases their production in the future. If an entrepreneur knows they can borrow money, use that money to buy capital and earn 7% on the investent, they will be willing to pay up 7% interest to a lender. With risk, entrepreneurs will add a buffer in case the investments don't work out, so the entrepreneur may be willing to borrow at up to 5% interest leaving a 2% cushion. The higher the risk, the higher the buffer the lender will demand.
"Subjective time preference" is a fancy way of saying that people would rather have stuff today than stuff tomorrow. People can be impatient. However, some people are more impatient than others and some people need to save up for various things such as houses, cars and retirement. The differences between people's "time preference" means that there is an opportunity for beneficial trade. Someone who wants money today can trade with someone who wants money tomorrow in the form of a loan.
Supply for loans consists of people who have money that they do not want to spend immediately. They want to spend it in the future instead. They could hold the money, but inflation will destroy some of their spending power. Someone who does not have any "productive investments" that they can make for themselves will have to either find someone who does, or find someone who wants the money today. Lenders must find Debtors so that they can more their spending power into the future.
When the quantity of loans desired equals the quantity of loans supplied, the market for loans will be in equilibrium and the interest rate will equal the "natural rate", which is similar to an equilibrium price for other goods. The natural rate is important because modern monetary policy focuses on controlling the economy by pushing the interest rate away from its natural rate. Expansionary policy (policy that tries to speed the economy up), is done by printing money and supplying that money to the market for loans. This shifts the supply curve out, driving down the interest rate and increasing the total quantity of loans made. Contractionary policy (which slows the economy down and reduces inflation) removes money from the loan market, driving up the interest rate and down the quantity of loans.
Monetary policy also impacts the inflation rate. Expansionary policy will increase inflation over time. Both creditors and debtors must react to the inflation if they want to still be in equilibrium. The Fisher Equation describes how inflation impacts the interest rate.
Fisher Equation: i = r + π
Where i = "nominal" interest rate - the interest rate in terms of money
r = "real" interest rate - the interest rate in terms of goods
π = the inflation rate
High inflation means that the nominal interest rate must be higher to take into account that money in the future will buy fewer goods because of inflation. For example, suppose one person lends someone else 100 apples today in exchange for 105 apples next year. If apples cost $1 and inflation is 0, the loan will be at 5% - $100 today for $105 next year. If inflation is at 100%, apples next year will cost $2. The "real" loan will have to be at 110% interest because 105 apples in the future will cost $210, not $105.*
As π gets added to the interest rate, the low rates from expansionary policy will become higher and higher. Likewise, if the monetary authority pushes up rates using contractionary policy, eventually the interest rates will fall down below their initial position. The constant up and down of the interest rates can play havoc on entrepreneurs, borrowers and lenders trying to coordinate their actions over time, but the Federal Reserve doesn't care, because they are jerks. That's a good introduction to what interest rates do and the role they play in society.
*Technically the rates are multipled, but addition comes pretty close:
(1+i)=(1+r)*(1+π) = (1+(r+π)+(rπ)) and normally the rπ term is too small to matter.
Demand for loans comes from two main sources: productive investments and subjective time preference. "Productive investments" means that people can use money today to buy capital, which increases their production in the future. If an entrepreneur knows they can borrow money, use that money to buy capital and earn 7% on the investent, they will be willing to pay up 7% interest to a lender. With risk, entrepreneurs will add a buffer in case the investments don't work out, so the entrepreneur may be willing to borrow at up to 5% interest leaving a 2% cushion. The higher the risk, the higher the buffer the lender will demand.
"Subjective time preference" is a fancy way of saying that people would rather have stuff today than stuff tomorrow. People can be impatient. However, some people are more impatient than others and some people need to save up for various things such as houses, cars and retirement. The differences between people's "time preference" means that there is an opportunity for beneficial trade. Someone who wants money today can trade with someone who wants money tomorrow in the form of a loan.
Supply for loans consists of people who have money that they do not want to spend immediately. They want to spend it in the future instead. They could hold the money, but inflation will destroy some of their spending power. Someone who does not have any "productive investments" that they can make for themselves will have to either find someone who does, or find someone who wants the money today. Lenders must find Debtors so that they can more their spending power into the future.
When the quantity of loans desired equals the quantity of loans supplied, the market for loans will be in equilibrium and the interest rate will equal the "natural rate", which is similar to an equilibrium price for other goods. The natural rate is important because modern monetary policy focuses on controlling the economy by pushing the interest rate away from its natural rate. Expansionary policy (policy that tries to speed the economy up), is done by printing money and supplying that money to the market for loans. This shifts the supply curve out, driving down the interest rate and increasing the total quantity of loans made. Contractionary policy (which slows the economy down and reduces inflation) removes money from the loan market, driving up the interest rate and down the quantity of loans.
Monetary policy also impacts the inflation rate. Expansionary policy will increase inflation over time. Both creditors and debtors must react to the inflation if they want to still be in equilibrium. The Fisher Equation describes how inflation impacts the interest rate.
Fisher Equation: i = r + π
Where i = "nominal" interest rate - the interest rate in terms of money
r = "real" interest rate - the interest rate in terms of goods
π = the inflation rate
High inflation means that the nominal interest rate must be higher to take into account that money in the future will buy fewer goods because of inflation. For example, suppose one person lends someone else 100 apples today in exchange for 105 apples next year. If apples cost $1 and inflation is 0, the loan will be at 5% - $100 today for $105 next year. If inflation is at 100%, apples next year will cost $2. The "real" loan will have to be at 110% interest because 105 apples in the future will cost $210, not $105.*
As π gets added to the interest rate, the low rates from expansionary policy will become higher and higher. Likewise, if the monetary authority pushes up rates using contractionary policy, eventually the interest rates will fall down below their initial position. The constant up and down of the interest rates can play havoc on entrepreneurs, borrowers and lenders trying to coordinate their actions over time, but the Federal Reserve doesn't care, because they are jerks. That's a good introduction to what interest rates do and the role they play in society.
*Technically the rates are multipled, but addition comes pretty close:
(1+i)=(1+r)*(1+π) = (1+(r+π)+(rπ)) and normally the rπ term is too small to matter.