The Cost of Money (2)
by MaestriHow 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 ?sh today for ?shin 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 ?sh, so he might be unwilling to “lend” a ?sh today for anything less than three ?sh 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 dif?cult.
The risk inherent in the ?shnet project, and thus in Mr. Crusoe’s ability to repay the loan, would also affect the return investors would 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 ?sh, and many savers like Ms. Robinson and Mr. Friday. Therefore, people use money as a medium of exchange rather than barter with ?sh. When money is used, its value in the future, which is affected by in?ation, comes into play: the higher the expected rate of in?ation, the larger the required return. We discuss this point in detail later in the chapter.
Thus, we see that the interest rate paid to savers depends in a basic way (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 in?ation. Producers’ expected returns on their business investments set an upper limit on 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 rates of interest offered by producers.6 Higher risk and higher in?ation also lead to higher interest rates.
What is the price paid to borrow money called?
What are the two items whose sum is the “price” of equity capital?
What four fundamental factors affect the cost of money?
Taken From : Five-Minute MBA – Corporate Finance
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