Articles, Blog

Interest as rent for money | The monetary system | Macroeconomics | Khan Academy

Interest as rent for money | The monetary system | Macroeconomics | Khan Academy

Voiceover: What I want to do in this video is talk a little bit about
money and interest rates and do it in kind of a
microeconomic framework, so that we understand the relationship between the supply of
money and demand for money and the price of money, which we’ll see is what interest rates actually are. Once we do that, then we’ll
be able to be more fluent in discussing money and
interest rates and supply and demand and price of money in a macroeconomic context. Maybe the most confusing thing, when you view money in
a microeconomic context is what is the price of money? You might already be
guessing the price of money is the interest rate. To understand that a little
bit better, the best way to think about it is you’re
not necessarily buying money. Interest is rent on money. If I said, “What is the
price of an apartment “in my neighborhood?” Someone might say a one-bedroom apartment, and that actually is
pretty close to the prices where I live, here in northern California. If you want even the most basic, one-bedroom apartment,
it’s going to run you about $1200 per month, which is about $14,400 per year. We should say per apartment per year. This is essentially the
cost of your apartment. Now, if I went to the bank and I said, “Hey, I want to borrow $10,000.” Maybe I want to buy a car or something, they would quote an interest rate. They would say, “Okay, you can borrow that “at an interest rate of – I don’t know. Interest rates are pretty low right now. They’ll say, “You can borrow
that at an interest rate “at 5%.” To see that is essentially
the cost of renting money, we could essentially
just say that this is 5 – We could view this as
$0.05 per dollar per year. Once again, when you’re
renting an apartment, it was $14,000 per apartment per year. Now, at an interest rate of 5%, that is $0.05 per dollar per year. It’s the exact same thing. This right over here is the rental price on the actual money that I’m borrowing. Once you have that in your head and you feel comfortable with that, now we can actually draw
a supply and demand graph and the microeconomics context. Now that we know how to
think about the price of money. Let’s draw a little
supply and demand diagram right over here and we’re
going to, like we often do in our little economic models we do, we’re going to super oversimplify it. We’re going to not think
about things like credit risk and the chances of probability
that people do pay back or won’t pay back the
money and things like (unintelligible) and all of that. We’ll just assume that
everyone is going to pay back the money and they’re all risk free. They’re all going to do
exactly what they said. In this axis right over here, this is – Let’s call this the
market for borrowing money for 1 year. As we’ll see and you might already know, they’ll have different
prices for borrowing money for different lengths of time. I might charge you more
to borrow money for a year than I would charge
you for borrowing money for a month, because
maybe I won’t have access to that money or there’s a bigger risk that something might happen in that year, so I’ll charge you more for it. I have to fix the year. The market for borrowing money for 1 year. Most of these supply and demand graphs, the vertical axis, we have price, but now, as we just indicated, the price of money is really just the interest rate. I’ll call this price, so this is our – Same yellow, so this is our price axis and it’s measured as
interest rate percentage. Interest rate is how
we’re going to measure it. This right over here, let’s
say that that is 30% interest, this is 15% interest, and
then this would be 10%, 5%, this would be 20%, 25%. Pretty good. Then over here we would
have the quantity of money and I’ll just pick some values here. We could even say that that
is in billions of dollars. We could size it right, based
on whether we’re talking about our town, our city, or
whatever, the whole world, or whatever it is. It depends on what
currency and all of that, but we’re just assuming
that we’re on some island with one currency and all the rest. Let’s say that this is 1
billion, 2 billion, 3 billion, 4 billion, and 5 billion. You can imagine, let’s first think about the demand curve. We could think of it as
a marginal benefit curve. Those first few dollars
that are out to be lent, there are someone who is going to get a huge marginal benefit of it. They want to take that,
either they want to borrow it and use it for some type of consumption that they want to buy
that would make them very, very, very happy, or at least
they think it’ll make them very happy, or they want
to use it for some type of investment, where they’re like, “Wow, if I could just borrow some money, “I have this no-risk
investment that’s just going “to make me a gazillionaire.” Those first few dollars
there’s huge demand, huge marginal benefit for you. You could use as a willingness to pay for those first few dollars is very high, so maybe it is way up here. People are willing to pay an excess of 30% for those first few dollars. Then, as there’s more and more dollars, the incremental next borrower
gets a little bit less marginal benefit from it. You would have a declining demand curve that looks something like this. This is the exact same thought process as you would have if we were
thinking about the market for ice cream of if we’re
thinking about the market for apartments or for anything else. This is our demand curve. When we think about the supply curve, same exact thought process
as we would for supply of any product. Those first few dollars, the
people lending the money, there are probably people
there willing to lend for very little. They have nothing else
to do with that money. Another way to think of it is
they have very little to do with that money. Their marginal cost of lending that money is very low. The supply curve might start over here. People will start to be
willing to lend the money to very low interest rate. This looks like about 1%. Then, each incremental
dollar, the opportunity cost for that lender is going
to get higher and higher. The interest for that
next incremental dollar is going to get higher and higher. We’ve now drawn the
supply and demand graphs for the market for
borrowing money for 1 year. This is right here. This is the supply and this is in billions of dollars per year. This is how much is going
to be lent in that year and it’s for borrowing money for a year. As we see, we can view
money just like we can view any other product. There’s going to be an
equilibrium price here, an equilibrium quantity. The way I drew it right over
here, the equilibrium price and remember the price
of money is really just the interest rate. The equilibrium price
right over here is 10%, which you could view as
$0.10 per dollar per year. The equilibrium quantity
of money that gets lent and borrowed looks like it’s about 2.7 or 2.8 billion dollars gets
lent and borrowed in that year, in each year. When we look at it this way,
then we can start thinking about some macroeconomics phenomenon. What happens if all of a
sudden everybody in the world or in our little universe
right over here gets a little bit more money
thrown in their pocket. The government prints a bunch of money, drops it from helicopters,
and everyone has more money in their pockets. Well, then, all of a sudden,
at any given interest rate, the supply will go up. The supply curve will
shift in this direction, so we might have a new
supply curve that looks something like this. We might have a new
supply curve that looks something like this. Then, also, maybe the demand will go down. At any given interest
rate, at any given price, there will be less demand,
because those people who needed to borrow money, now they have to borrow less money. This will shift to the left. The new demand curve might look like that. What happened? What would be our new equilibrium price? It depends how much I
shift one or the other, but the way I drew it,
our equilibrium quantity doesn’t change much, but it could change, depending on how much the
supply or demand shifts. What does definitely
happen, when that money got printed and distributed
to all of these people, is now all of a sudden, the
equilibrium interest rate has gone down. The equilibrium interest rate now, based on the way I drew
it, looks like it’s closer to about, I don’t know, about 6%. The whole – You can even think of
another reality where, all of a sudden, money
disappears from the market, or a reality where, for whatever reason, because of good marketing
or a psychological shift in people, all of a sudden,
people want to save less, so that there is less supply of money. Or maybe, all of a sudden, there’s all these great investment opportunities, so now there’s more demand for money and you could think about how these curves would shift and what would
happen to the interest rate. Just how you would think
about it for any good or service in a microeconomic context.

Tagged , ,

18 thoughts on “Interest as rent for money | The monetary system | Macroeconomics | Khan Academy

  1. @chocomalk By buying and selling government securities the fed can shift the supply and demand curve at will. Basically.

  2. @chocomalk by lowering interest rate (buying government securities) the demand curve shifts… at least that is the idea. It is not always the case, but in a perfect, ideal world that is what would happen.

  3. just so to figure out the price of money today, fed interest rates are 0- 0,25%… the money is worthless folks =) Commercial Banks have no initiative to lend.
    Instead they are just getting paid by central banks for having and excess reserve currency held on hand. The market is dead.

    Respect for the video. Very educating and simply explained. Respect for your teaching talent!

  4. Thank you Sal. I never knew Economics would be so interesting. *sigh* I can study it in school because I'm in grade 11. You can turn any dry subject and turn it into a fun video game like subject. Thank you so much

  5. This and future videos are not in the core finance playlist on khan academy itself
    KHAN ACADEMY ROCKS! Sal, Please do more videos on Python, Pygame and other programming laungadges

  6. " They use 100% of the available money supply and achieve a 5% return" <- that is impossible if you think about it. If someone in the world (instead of country, because in country you got export import) makes 5%, someone (maybe spread over many people) else in the world has to lose 5%. After all, in a closed circle, it is impossible for everyone to win. The aggregate has to be zero.

  7. The way he explains the slope of the Demand (minute 5:41) confused the heck out of me. Why would people be willing to pay 30% to borrow a few dollars? That makes no sense.

    It should be reversed, if the interest rate is 30%, people can't afford to borrow too much, to the quantity is only a few dollars.

    At 5:45 declining marginal utility might apply to goods, but to money?… Yeah it makes no difference to the slope. Strange explanations though.

  8. Well if you look at the curve you see that way up around 30% the demand for money is really low, about less than 1 billion. As you go down to like 10% you'll see the demand for money becomes a lot more almost 3 billion which is very logical

  9. Yeah, I didn't say that there is anything wrong with the slope (or curve, or anything you call the demand line). He said on 5:40 – 5.48: "People are willing to pay excess of 30% for those first few dollars and as there are more and more dollars, the incremental next borrower get less marginal benefit from it". That's what I think is illogical way to explain the curve/slope/demand line.

  10. But my textbook says the following: Increase in the rate of money growth (i.e. Feds creating more money) causes a percent increase in the rate of inflation according to the basic Quantity Theory of Money. And according to the Fisher Equation, a percent increase in the rate of inflation in turn causes a percent increase in the nominal interest rate. But according to the video, an increase in money supply decreases the interest rate. So WHO IS RIGHT?

  11. The preconceptions in this video are entirely based on the negative effects of the propagation of multiple reasons and the consequence thereof. 

  12. You might be confusing the concepts of marginal cost and supply. Money doesn't have marginal cost when you're the one lending it. Lending $1,000 costs the same as lending $100,000; it is perfectly elastic. There is no point where lending more money in a perfectly competitive market leads to smaller profit. Your supply and demand curves follow the logic of treating money like any other good, which is correct, but the explanation given seems to imply something different.

  13. Sir your videos are the reason iam capable to do exams with 10 grades. Idk how you have it in USA, here 10 is like a A plus. Masive respect for your videos. I will share them in our fb study group.

Leave a Reply

Your email address will not be published. Required fields are marked *