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As mentioned in the Growth Theory chapter, capital investment typically requires a firm to borrow money. This money comes from lenders. The market where borrowers and lenders come together is called the loanable funds market. Borrowers are the demanders, lenders are the suppliers, and the price is the interest paid on the loan. Example: someone borrows $10,000 at the start of a year and at the end of the year pays the lender $11,000 to conclude the transaction. That $11,000 represents the original $10,000, called the principal, plus $1,000 in interest. Since the loan was for 1 year and $1,000 is 10 percent of $10,000, the interest rate on this loan was 10 percent per year.
Loans are often repaid in monthly installments, but calculating the principal and interest components of a series of monthly payments gets complicated. We will therefore stick with the simple scenario where a loan is made at the start of a year and paid off at the end of that same year in a single lump sum.
For the borrower, the interest represents the cost of borrowing. The cost is justified if the borrower is able to cover the cost by using the borrowed money to make more money. For example, someone might have a house that needs $10,000 worth of repairs but after that will sell for $20,000 more. Of the added $20,000, $11,000 will go back to the lender, but the borrower who sold the fixed-up house will pocket the remaining $9,000 as profit. Not every deal has to be that good, but the expected return of the borrower’s capital investment needs to be at least large enough to cover the cost of borrowing. In this case, the capital investment needed to yield a return of at least 10 percent on the $10,000 borrowed. That is, the $10,000 in repairs needed to increase the value of the house by at least $11,000 dollars.
For the lender, the interest represents the reward for saving—that is, for not engaging in consumption spending. To put the point another way, the interest covers the opportunity costs the lender incurs by passing up certain purchases. The interest also compensates the lender for the risk that the borrower will default on the loan. If the borrower can’t pay back the loan in full, the lender will lose some of the money lent. Interest helps to make the risk of default worth taking. In general, the higher the risk of default, the higher the interest rate demanded by the lender.
Real versus Nominal Interest Rates
Inflation complicates the picture. Suppose inflation is running at 2 percent per year, so that a good that costs $1,000 on January 1 will cost $1,020 a year later. In that case, a lender needs to charge 2 percent interest just to keep up with inflation. More generally, the nominal interest rate verbally agreed to as part of the loan needs to allow for inflation. The equation that summarizes the relationship and gives the real interest rate—the borrower’s true cost and the lender’s true reward, after adjustment for inflation—is the Fisher equation:
\(\text{Real Interest Rate} = \text{Nominal Interest Rate} - \text{Inflation Rate}\)
This complication is more than a matter of a tiny bit of extra math. It’s a genuine problem because neither the lender nor the borrower knows the inflation rate in advance. Both parties therefore have to make their best guess. When the inflation rate is higher than expected, the real rate comes out lower than anticipated, which works to the borrower’s advantage. Conversely, when the inflation rate is lower than expected, the real rate comes out higher than anticipated, which works to the lender’s advantage. (For a little more on this issue, see also the end of the Inflation chapter.)
