Suppose that your income this year is $10k, and your expected income over the next five years is $250k (an average of $50k per year). Perceiving that your future self will have a far greater income than your present self, you decide that some income redistribution would be appropriate and borrow $20k. Your present income then increases to $30k, while your expected income only decreases to $230k (an average of $46k per year). By redistributing your income from the future to the present it can be available when you need it most
But you grossly overestimated your future income. Instead of $250k, your future income will actually be $150k. The $30k loan had been given on false expectations. You increase your consumption: not only do you have more money now but also expect to have more in the future. But when the new year begins and you discover your mistake. Instead of a $50k income you have only a $30k income, and moreover, you still have to pay back your loan! Your income actually declines after the first year from $30k to $26k.
Overestimating your future income by $100k created a personal bubble. For a while you enjoyed a higher standard of living, and your contribution to GDP doubled. In the long run, however, you are burdened with a debt that can only be repaid with a significant decline in your lifestyle and future contribution to GDP.
As painful as this personal recession may be, it is an inevitable response to your past mistakes. It could be delayed by borrowing more money, but doing so would only make the eventual recession more painful. Even if you successfully delay the recession once or twice, it is a strategy which cannot be repeated indefinitely. Lenders would eventually look upon your impoverished future and decline to loan you any more money, and you would be facing a more painful recession than the one which had been delayed.
The above table shows supply and demand for some product at varying prices. At $100 many units could be supplied, but none is be sold because there is no demand. At $0 no units are supplied, even though many are demanded. In both cases there is no profit to be made, because either nobody buys or nobody sells.
Under normal conditions the price would move toward $50. A supplier who set the price higher would be paying for goods which he cannot sell, while one who set the price lower would be turning away potential customers. In both cases it is more profitable to adjust the price toward $50. When the price is not $50, there is a sub-optimal use of scarce resources, that is, resources are wasted producing something which is not demanded or not exploited when there is demand.
Sometimes, however, sellers are prohibited from setting prices. Suppose a politician passes legislation to control the price. He decides upon a price ceiling of $30. What would then occur? A quick glance at the table above tells us that 700 units will be supplied and 1300 demanded, creating a shortage of 600 units. At $30 nobody sells after 700 units have been bought, even though more is demanded.
An important role of prices is to ration resources. Suppose that each buyer purchases 1 unit at $50 and 2 at $30 (each buyer purchases more of the product when the price is lower). When the price is set at $50 there are 1000 people who buy 1 unit each; when the price is set at $30 there are only 350 people who buy 2 units each. With the price ceiling fewer people enjoy more product at lower prices, but at the expense of a greater number of people who must go without.
Interest rates are the price of borrowing money (i.e. credit). Above is a table showing supply and demand for credit at varying interest rates. At 20% interest a large quantity of credit is supplied, but none is be sold because there is no demand. At 0% interest no credit is supplied, even though a large quantity is demanded. In both cases there is no profit to be made, because either nobody sells or nobody buys.
Credit is no different than any other product or resource. People sell more credit when they expect a high rate of return, and buy less credit when they expect high interest payments.
Under normal conditions the interest rate would move toward 10%. A supplier who set the interest rate higher would have some credit to sell but no buyer, while one who set the interest rate lower would be turning away potential borrowers. In both cases it is more profitable to adjust the interest rate toward 10%. When interest rates are not at 10%, there is a sub-optimal use of credit.
Sometimes, however, lenders are prohibited from setting interest rates. Suppose a politician passes legislation to control the rate. He decides upon an interest rate ceiling of 7%. What would then occur? A quick glance at the table above tells us that $700k of credit will be supplied and $1300k demanded, creating a shortage of $600k. At a 7% interest rate nobody sells credit after $700k has been sold, even though more is demanded.
An important role of interest rates is to ration credit. Suppose that each buyer purchases $1k of credit at 10% interest and $2k at 7% (each buyer purchases more credit when the price is lower). When the interest rate is set at 10%, there are 1000 people who buy $1k of credit each; when the interest rate is set at 7% there are only 350 people who buy $2k of credit each. With the interest rate ceilig fewer people enjoy more credit at a lower price, but at the expense of a greater number of people who must go without.
Perceiving this problem the politician passes new legislation. New money will be printed until its supply is enough so that at least 1000 people can buy credit at 7%. Since each buyer purchases $2k and only $700k is supplied, $1.3k must be printed for 1000 people to buy credit. By printing money a politician can lower the interest rate. Before the legislation was passed 1000 people bought $1000 of credit each, but afterward they can buy $2000 each! More future income is redistributed to the present.