Interest as rent for money

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.