The Cost of Money: Production Opportunities Time Preferences For Consumption Risk Inflation

The Cost of Money
The four most fundamental factors affecting the cost of money are
1. production opportunities,
2. time preferences for consumption,
3. risk, and
4. inflation.
To see how these factors operate, visualize an isolated island
community where people live on fish. They have a stock of fishing gear
that permits them to survive reasonably well, but they would like to
have more fish. Now suppose one of the island’s inhabitants, Mr. Crusoe,
had a bright idea for a new type of fishnet that would enable him to
double his daily catch. However, it would take him a year to perfect the
design, build the net, and learn to use it efficiently. Mr. Crusoe would
probably starve before he could put his new net into operation.
Therefore, he might suggest to Ms. Robinson, Mr. Friday, and several
others that if they would give him one fish each day for a year, he would
return two fish a day the next year. If someone accepted the offer, the
fish that Ms. Robinson and the others gave to Mr. Crusoe would
constitute savings, these savings would be invested in the fishnet, and
the extra fish the net produced would constitute a return on the
investment.
Obviously, the more productive Mr. Crusoe thought the new fishnet
would be, the more he could afford to offer potential investors for their
savings. In this example, we assume that Mr. Crusoe thought he would
be able to pay (and thus he offered) a rate of return—he offered to give
back two fish for every one he received. He might have tried to attract
savings for less—for example, he might have offered only fish per day
next year for every one he received this year, which would represent
a rate of return to Ms. Robinson and the other potential savers.
How attractive Mr. Crusoe’s offer appeared to a potential saver would
depend in large part on the saver’s time preference for consumption. For
example, Ms. Robinson might be thinking of retirement, and she might
be willing to trade fish today for fish in the future on a one-for-one basis.
On the other hand, Mr. Friday might have a wife and several young
children and need his current fish; so he might be unwilling to “lend” a
fish today for anything less than three fish next year. Mr. Friday would
be said to have a high time preference for current consumption, and Ms.
Robinson, a low time preference. Note also that if the entire population
were living right at the subsistence level, time preferences for current
consumption would necessarily be high; aggregate savings would be
low; interest rates would be high; and capital formation would be
difficult.
The risk inherent in the fishnet project (and thus in Mr. Crusoe’s ability

to repay the loan) also affects the return that investors require: The
higher the perceived risk, the higher the required rate of return. Also, in
a more complex society, there are many businesses like Mr. Crusoe’s,
many goods other than fish, and many savers like Ms. Robinson and Mr.
Friday. Therefore, people use money as a medium of exchange rather
than barter with fish. When money is used, its value in the future, which
is affected by inflation, comes into play: The higher the expected rate of
inflation, the larger the required dollar return. We discuss this point in
detail later in the chapter.
Thus, we see that the interest rate paid to savers depends
1. on the rate of return that producers expect to earn on invested capital,

2. on savers’ time preferences for current versus future consumption,
3. on the riskiness of the loan, and
4. on the expected future rate of inflation.
Producers’ expected returns on their business investments set an upper

limit to how much they can pay for savings, while consumers’ time
preferences for consumption establish how much consumption they are
willing to defer and hence how much they will save at different interest
rates. Higher risk and higher inflation also lead to higher interest
rates.
Interest Rate Levels

Borrowers bid for the available supply of debt capital using interest
rates: The firms with the most profitable investment opportunities are
willing and able to pay the most for capital, so they tend to attract it
away from inefficient firms and firms whose products are not in
demand. At the same time, government policy can also influence the
allocation of capital and the level of interest rates. For example, the
federal government has agencies that help designated individuals or
groups obtain credit on favorable terms. Among those eligible for this
kind of assistance are small businesses, certain minorities, and firms
willing to build plants in areas with high unemployment. Still, most
capital in the United States is allocated through the price system, where
the interest rate is the price.
Figure 7.1 shows how supply and demand interact to determine interest

rates in two capital markets. Markets L and H represent two of the many
capital markets in existence. The supply curve in each market is upward
sloping, which indicates that investors are willing to supply more capital
the higher the interest rate they receive on their capital. Likewise, the
downward-sloping demand curve indicates that borrowers will borrow
more if interest rates are lower. The interest rate in each market is the
point where the supply and demand curves intersect. The going interest
rate, designated as r, is initially for the low-risk securities in Market L.
Borrowers whose credit is strong enough to participate in this market
can obtain funds at a cost of , and investors who want to put their
money to work without much risk can obtain a return. Riskier
borrowers must obtain higher-cost funds in Market H, where investors
who are more willing to take risks expect to earn a return but also
realize that they might receive much less. In this scenario, investors are
willing to accept the higher risk in Market H in exchange for a risk
premium of .
Figure 7.1Interest Rates as a Function of Supply and Demand for

Funds
© CengageLearning®
Now let’s assume that because of changing market forces, investors

perceive that Market H has become relatively more risky. This changing
perception will induce many investors to shift toward safer investments
—referred to as a “flight to quality.” As investors move their money
from Market H to Market L, the supply of funds is increased in Market L
from to ; and the increased availability of capital will push down
interest rates in this market from to . At the same time, as investors
move their money out of Market H, there will be a decreased supply of
funds in that market; and tighter credit in that market will force interest
rates up from to . In this new environment, money is transferred from
Market H to Market L and the risk premium rises from to .
There are many capital markets in the United States, and Figure
7.1 highlights the fact that they are interconnected. U.S. firms also invest
and raise capital throughout the world, and foreigners both borrow and
lend in the United States. There are markets for home loans; farm loans;
business loans; federal, state, and local government loans; and
consumer loans. Within each category, there are regional markets as
well as different types of submarkets. For example, in real estate, there
are separate markets for first and second mortgages and for loans on
single-family homes, apartments, office buildings, shopping centers, and
vacant land. And, of course, there are separate markets for prime and
subprime mortgage loans. Within the business sector, there are dozens
of types of debt securities and there are several different markets for
common stocks.
There is a price for each type of capital, and these prices change over
time as supply and demand conditions change. Figure 7.2 shows how
long- and shortterm interest rates to business borrowers have varied
since the early 1970s. Notice that short-term interest rates are
especially volatile, rising rapidly during booms and falling equally
rapidly during recessions. (The shaded areas of the chart indicate
recessions.) In particular, note the dramatic drop in short-term interest
rates during the recent recession. When the economy is expanding,
firms need capital; and this demand pushes rates up. Inflationary
pressures are strongest during business booms, also exerting upward
pressure on rates. Conditions are reversed during recessions: Slack
business reduces the demand for credit, inflation falls, and the Federal
Reserve increases the supply of funds to help stimulate the economy.
The result is a decline in interest rates.
Figure 7.2Long- and Short-Term Interest Rates, 1972–2014
© 2016 Cengage Learning®
Source: St. Louis Federal Reserve, FRED

database, research.stlouisfed.org/fred2.
These tendencies do not hold exactly, as demonstrated by the period

after 1984. Oil prices fell dramatically in 1985 and 1986, reducing
inflationary pressures on other prices and easing fears of serious long-
term inflation. Earlier these fears had pushed interest rates to record
levels. The economy from 1984 to 1987 was strong, but the declining
fears of inflation more than offset the normal tendency for interest rates
to rise during good economic times; the net result was lower interest
rates.
The relationship between inflation and long-term interest rates is
highlighted in Figure 7.3, which plots inflation over time along with
long-term interest rates. In the early 1960s, inflation averaged per year
and interest rates on high-quality long-term bonds averaged . Then the
Vietnam War heated up, leading to an increase in inflation; and interest
rates began an upward climb. When the war ended in the early 1970s,
inflation dipped a bit; but then the 1973 Arab oil embargo led to rising
oil prices, much higher inflation rates, and sharply higher interest rates.
Figure 7.3Relationship Between Annual Inflation Rates and Long-
Term Interest Rates, 1972–2014
© 2016 Cengage Learning®
Inflation peaked at about in 1980. But interest rates continued to

increase into 1981 and 1982, and they remained quite high until 1985
because people feared another increase in inflation. Thus, the
“inflationary psychology” created during the 1970s persisted until the
mid-1980s. People gradually realized that the Federal Reserve was
serious about keeping inflation down, that global competition was
keeping U.S. auto producers and other corporations from raising prices
as they had in the past, and that constraints on corporate price increases
were diminishing labor unions’ ability to push through cost-increasing
wage hikes. As these realizations set in, interest rates declined.
The current interest rate minus the current inflation rate (which is also
the gap between the inflation bars and the interest rate curve in Figure
7.3) is defined as the “current real rate of interest.” It is called a “real
rate” because it shows how much investors really earned after the
effects of inflation are removed. The real rate was extremely high during
the mid-1980s, but it has generally been in the range of to since 1987.
In recent years, inflation has been quite low, averaging about a year,
and it was even negative in 2009, as prices fell in the midst of the deep
recession. However, long-term interest rates have been volatile because
investors are not sure if inflation is truly under control or is about to
jump back to the higher levels of the 1980s. In the years ahead, we can
be sure of two things:
1. Interest rates will vary, and
2. they will increase if inflation appears to be headed higher or decrease if
inflation is expected to decline.
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The Cost of Money

The risk inherent in the fishnet project (and thus in Mr. Crusoe’s ability

Thus, we see that the interest rate paid to savers depends

1. on the rate of return that producers expect to earn on invested capital,

Producers’ expected returns on their business investments set an upper

Interest Rate Levels

Figure 7.1 shows how supply and demand interact to determine interest

Figure 7.1Interest Rates as a Function of Supply and Demand for

Now let’s assume that because of changing market forces, investors

Figure 7.2Long- and Short-Term Interest Rates, 1972–2014

© 2016 Cengage Learning®

Source: St. Louis Federal Reserve, FRED

These tendencies do not hold exactly, as demonstrated by the period

© 2016 Cengage Learning®

Inflation peaked at about in 1980. But interest rates continued to

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