INTEREST - Interest Rent and Profit Interest The word...

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Interest, Rent, and Profit Interest: The word interest is used in two ways in economics. Sometimes it refers to the price for loanable funds. E.g. David borrows $100.00 from Mary and a year later pays her back $110.00 The interest is $10.00. Loanable Funds: Funds that someone borrows and another person lends, for which the borrower pays an interest rate to the lender. Interest can also refer to the return earned by capital as an input in the production process. The reason economist often refer to both the price for loanable funds and the return on capital goods as interest is that there is tendency for the two to become equal. Question Is there a difference between interest and interest rate? Answer Yes—Interest refers to an absolute dollar amount; the interest rate is a ratio of the annual interest to the principal amount. E.g. $100 -- $120 interest = $20 and interest rate = 20/100 =20%. Elements of Interest: (1) Payment for risk-bearing: Granting a loan to a customer involves great risk and as a result, part of the payment made for using capital is a payment for bearing the risk of having the money back too late or even losing it altogether. The greater the risk of losing the money, the higher the rate of interest changed. (2) Service charges: Every loan made usually involves considerable administrative expenses which often include the keeping of accurate records of the transaction involved and so forth. (3) Pure Interest: This is the actual price paid for the use of capital for the period of time under consideration. Loanable Funds: Demand and Supply: The equilibrium interest rate, or the price for loanable funds, is determined by the demand for, and supply of, loanable funds. The demand for loanable funds is composed of : a. The demand of consumption loans—households b. The demand for investment loans—businesses c. Government’s demand for loanable funds—U.S. Treasury may need to finance budget deficits by borrowing loanable funds 1
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The supply for loanable funds is composed of: a. People’s saving b. Newly created money The Demand for loanable funds: Consumption Loans Loanable funds are demanded by consumers because they have positive rate of time preference. Positive Rate of Time Preference: Preference for earlier availability of goods over later availability of goods. A person’s rate of time preference equals the percent increase in future consumption that the person needs to obtain before he or she will sacrifice some amount of present consumption. In short, positive time preference means—consumers prefer earlier availability of goods to later availability. E.g. most people would prefer to have a car today than a car 5 years from today. High rate of time preference signifies that a person greatly prefer present future consumption. Question
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This note was uploaded on 01/28/2011 for the course ECON 1 taught by Professor Sm during the Spring '10 term at Laney College.

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INTEREST - Interest Rent and Profit Interest The word...

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