Study Notes on Economics: Interest, Rent, and Profit

Chapter Overview

  • Key Topics: Interest, Rent, Profit

Loanable Funds

  • Loanable Funds Definition: Funds that someone borrows and another person lends, for which the borrower pays an interest rate to the lender.

  • Demand for Loanable Funds:

    • Composed of:

    • Demand for consumption loans

    • Demand for investment loans by business

  • Supply of Loanable Funds: Composed of people’s savings.

Consumer Demand for Loanable Funds

  • Key Concept: Consumers possess a positive rate of time preference, indicating a preference for earlier availability of goods over later availability.

  • Interest Payment Role: The interest payment is the price consumers pay to access goods sooner.

Investment Demand for Loanable Funds

  • Investors’ Behavior: Investors or firms demand loanable funds (or credit) to invest in capital goods and finance roundabout methods of production.

  • Roundabout Methods of Production: A production strategy that prioritizes producing capital goods first, which are then used to produce consumer goods.

Loanable Funds Market

  • Demand Curve: Illustrates different quantities of loanable funds demanded at varying interest rates.

  • Supply Curve: Shows different quantities of loanable funds supplied at different interest rates.

  • Equilibrium: Established through supply and demand forces, where the equilibrium interest rate and quantity of loanable funds at that rate are denoted as i<em>1i<em>1 and d</em>1d</em>1.

Why Do Interest Rates Differ?

  • Factors Influencing Interest Rates:

    • Risk: The likelihood that a borrower will default.

    • Higher risk leads to higher interest rates.

    • Lower risk leads to lower interest rates.

    • Term of the Loan: The duration until the loan is repaid.

    • Longer terms usually result in higher interest rates.

    • Shorter terms usually result in lower interest rates.

    • Cost of Making the Loan: Costs related to processing and administering the loan, affecting interest rates.

Nominal and Real Interest Rates

  • Nominal Interest Rate: The interest rate established by supply and demand in the loanable funds market.

  • Real Interest Rate: The nominal interest rate adjusted for expected inflation, expressed as:
    extRealInterestRate=extNominalInterestRate−extExpectedInflationRateext{Real Interest Rate} = ext{Nominal Interest Rate} - ext{Expected Inflation Rate}

Expected Inflation and Interest Rates

Part I

  • Starting point: 8% nominal interest rate with 0% actual and expected inflation.

  • When expected inflation rises to 4%, borrowers are willing to pay higher rates because they can repay loans with money that has lower purchasing power.

  • Lenders require higher rates to compensate for the diminished value of repaid dollars.

Part II

  • Demand and supply curves adjust such that lenders require 4% higher interest, settling the nominal interest rate at 12% with a real interest rate at 8%.

Present Value Calculation

  • Definition: The current worth of future income or receipts.

  • Formula for Present Value (PV): PV=An(1+I)nPV = \frac{A_n}{(1 + I)^n}

    • Where:

    • AnA_n = the amount of income or receipts in the future

    • II = interest rate (as a decimal)

    • nn = number of years into the future.

Present Value Example

  • Given:

    • A = $100

    • I = 0.10 (10%)

    • n = 1

  • Calculation:
    PV=100(1+0.10)1=1001.10=90.91PV = \frac{100}{(1 + 0.10)^1} = \frac{100}{1.10} = 90.91

Value of Investment to Business Firms

  • To find today’s value of an investment earning $100 annually for 3 years at 10% interest: PV=100(1.10)1+100(1.10)2+100(1.10)3PV = \frac{100}{(1.10)^1} + \frac{100}{(1.10)^2} + \frac{100}{(1.10)^3}

    • Solution:

      • =1001.10+1001.21+1001.331= \frac{100}{1.10} + \frac{100}{1.21} + \frac{100}{1.331}

      • =90.91+82.64+75.13=248.68= 90.91 + 82.64 + 75.13 = 248.68

Self-Test: Loanable Funds and Capital Goods

  • Question 1: Why do prices for loanable funds tend to equal the return on capital goods?

    • Response: Equal prices provide a monetary incentive; if returns exceed costs, capital stock increases and returns decrease.

Self-Test: Real Interest Rate Importance

  • Question 2: Why does the real interest rate matter to borrowers and lenders?

    • Response: Real interest rate reflects true cost to borrowers and true return to lenders, based on inflation-adjusted values.

Self-Test: Present Value Calculation

  • Question 3: What is the present value of $1,000 two years from today at a 5% interest rate?

    • Answer: $907.03. Calculation:
      PV=1000(1+0.05)2PV = \frac{1000}{(1 + 0.05)^2}

Self-Test Discussion: Capital Good Purchase

  • Question 4: Should a firm invest in a capital good costing $7,000 that earns $2,000 per year for 4 years at 8%?

    • Answer: No, as the present value of $8,624.25 is less than the cost. Calculation shown previously demonstrates this.

Economic Rent

Definition and Overview

  • Economic Rent: Payment exceeding opportunity costs for a resource.

  • Pure Economic Rent: Exemplifies payments exceeding opportunity costs when opportunity costs are zero, initially applied to land.

Contemporary Use

  • Terms economic rent and pure economic rent now encompass factors beyond land.

  • David Ricardo's Argument: High land rents are a result of high commodity prices, not their cause.

Determinants of Economic Rent

  • Varies based on perspective:

    • An example: A librarian earning $50,000 receives $2,000 in economic rent if their next best alternative is $48,000.

Pure Economic Rent and Land

  • Defined as payments to factors fixed in supply, leading to zero opportunity costs.

  • Total Supply of Land: Considered inelastic in the short term.

Competing Uses of Land

  • Individual parcels have opportunity costs associated with competing uses. Developers must bid to draw land from these uses.

Artificial vs. Real Rents

  • Artificial Rent: Created by government interventions, lacking natural market forces.

  • Real Rent: Exists without government creation, leading to socially productive resource use.

Self-Test Examples of Economic Rent Variability

  • Example of economic rent from Jones' varying salaries in broadcasting versus academia showcases differing opportunity costs.

Implications of Pure Economic Rent

  • If Nick earns a salary that constitutes pure economic rent, this suggests his next best alternative salary is $0.

Social Consequences of Competing for Rents

  • Competing for artificial rents may lead to resource allocation aimed merely at transferring economic rent between firms rather than increasing overall productivity.