Fiscal lessons: 3 (theory of interest rate - induction)

Basically ‘debt’ means the state of owing something. Whenever the term debt is coined the first thing that comes to our mind is ‘interest rate’. The concept of interest rate goes back to thousands of years. Apparently, it’s an old idea.

Starting with the basics, interest rate simply means a few percent a year. Now the question is why it is a few percent a year? And why not something completely different? And why it is even a positive number? Or what explains that? To understand these basic questions, let’s go back to history of thought.

Eugen Von Bohm-Bewark, an Austrian economist from the 19^th century, wrote a book on theory of interest. He had given the three basic reasons of what causes interest rate. One of them was technical progress. As the economy as a whole starts knowing the easier ways in which the work can be done, the productivity level increases. So as per this concept, we can say that the interest rate is nothing but a rate at which technology is progressing. So if we say that interest rate is 5%, it means that the technical progress is speeding at 5% level.

Another was advantages of roundaboutness. It says that there’s a direct relationship between roundabout production and productivity level. There’s a simple explanation to this. That if someone asks us to do some work right now then we’d be doing it in the most direct way possible. But if we have got some more time to do it then perhaps we’d be doing it in a more roundabout manner. Like if we have got some extra time, we may analyze the whole situation first or we may look for another method or technique or something which can enhance the quality of work. In short, more the time we get to complete a work, better are the chances to get it done effectively. So may be interest rate is the measure of advantages to roundaboutness.

The third reason that he gave was time preference. The term itself suggests that rational people prefers present over future. Basically this falls into behavioral economics. It’s a psychology of humans that if we are given, let’s say, some chocolates or some confects for that matter, we’d prefer to eat them now instead of eating them in a near future with more joy. This is thoroughly explained in the Marshmallow experiments conducted by Zimbardo. It says that even if we know that we’d be enjoying more advantages by consuming the thing in future than in present, we have a tendency to be impulsive and we’d rather prefer to consume it straight away. So may be interest rate is the rate of time preference. So if we say that interest rate is 7%, it means that people are 7% happier to get something now to get in the future.