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Chapter 26 Interest, Present Value, Rent, and Profit
This chapter examines four topics related to factor markets; interest, present value, economic
rent, and economic profit.
Interest – the payment for the use of loanable funds.
Interest is the payment received by savers for making loanable funds available. Interest is the
payment made by borrowers to use loanable funds. The interest rate is determined by the supply
of and the demand for loanable funds.
The Loanable Funds Market
The supply of loanable funds comes from households that save (do not consume) part of their
income. Household saving is motivated by the desire to accumulate wealth for retirement or for
major future expenditures (e.g. a down payment on a house, college education, etc.). Household
saving is also motivated by the desire to earn interest on savings. The interest earned will allow
for greater consumption in the future.
Example 1: Sanjiv Saver puts $10,000 in savings in Year 1. Sanjiv earns a 4% real interest rate
on the savings for twenty years. Sanjiv’s savings will now have 119% more buying power. Sanjiv
can use this increased buying power to help finance his retirement, for a major purchase (e.g.
down payment on a house), or for other consumption.
The quantity of household saving will be directly related to the interest rate. As the interest rate
increases, the quantity of household saving will increase. Thus, the savings supply curve (or
loanable funds supply curve) will be upward sloping, as illustrated in Example 2 below:
Example 2:
Interest
Rate
Quantity of Loanable Funds
The private demand for loanable funds comes from:
1. Consumers, who have a positive rate of time preference. A positive rate of time preference
means consumers prefer earlier consumption to later consumption. This positive rate of time
preference causes people to be willing to borrow (and pay interest) in order to consume now
rather than later. Current consumption, financed by borrowing, is more expensive than future
consumption, financed by accumulated savings.
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26 - 1 Interest, Present Value, Rent, and Profit