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 the 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 double his daily catch. However, it would take a year to perfect the design, build the net, and learn to use it efficiently, and 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 during all of the next year. If someone accepted the offer, then the fish that Ms. Robinson or one of 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 100 percent 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 1.5 fish per day next year for every one he received this year, which would represent a 50 percent 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 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 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, hence how much they will save at different interest rates.1 Higher risk
and higher inflation also lead to higher interest rates.

  • What is the price paid to borrow debt capital called?
  • What are the two items whose sum is the cost of equity?
  • What four fundamental factors affect the cost of money?