Question

*"Interest is the price one pays to have something now." It is related to a person's level of patience. An impatient person is willing to pay a higher rate of interest to have something now.

*"The Theory of Interest," Irving Fisher, Yale University

Assume that you want to buy a car that costs $28000. You don't have the money to pay cash so you must borrow it from a bank. The bank will charge you interest on the loan, right?

Assume that you have $28000 in an account in a bank. You decide to use your own money to buy the car. You withdraw the $28000 from the bank. What are you giving up to have the car now? Interest!

So what is the essence of interest? What does it measure?

What would Irving Fisher say about your statement?

Answer 1

Assume that you have $28000 in an account in a bank. You decide to use your own money to buy the car. You withdraw the $28000 from the bank. What are you giving up to have the car now? Interest!

So what is the essence of interest? What does it measure?

What would Irving Fisher say about your statement?

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Suppose that a person has $28000 in a bank account, and he uses the entire money to buy a car.

The person gives up the interest that he could have earned, had he allowed the money to grow in the bank account.

Thus, interest actually measures the price of money, or the opportunity cost of money.

For a borrower, the interest rate is how much he is willing to pay for money. For the lender, the interest rate is how much he is willing to receive for parting with his money.

A high interest rate means that money is costly. It favors saving over borrowing. A low interest rate means that money is cheaper, and it favors borrowing over saving.

As per I. Fisher, interest is the price that a person pays for immediate consumption. It means, sacrificing future consumption for present consumption. This person is more interested in present satisfaction than future satisfaction.

This does imply that the person is impatient, and that he cannot wait for the future.

In macroeconomic terms, a high saving rate translates to a high investment rate, and GDP growth. A high consumption rate raises GDP for now, but future growth is not assured.

Thus, a rational decision maker must properly balance between present consumption and future savings.