Hi everyone, welcome to Finance for Non-Finance Professionals, Week one, Lecture one. Today, we're going to be talking about human nature and the time value of money. And that's basically going to be a discussion of interest rates. Let me think about making you a deal. I could give you $100 right now, or you could wait five years and I'll give you a hundred dollars five years from today. Okay, which will you rather have? If you ask almost anyone anywhere in the world, children, middle aged people, old people, anywhere in the world they'll almost always say today I'd rather have the money today than wait for it, why? Why would people rather have stuff today than wait for it? Well, let's think about it. There's a couple good reasons from the basic economics of it. If I had the money today, I could take it and invest it. What could I do? I could put it in a bank, I could buy real estate, I could do lots of different things. I could invest it and earn some rate of return between now and five years from now. Also, things might be more expensive five years from now. When I go and wait for that money and you give me the $100 five years from now, I might not be able to buy as much. The other thing is that I don't know what's going to happen between now and five years from now. There's a lot of uncertainty and risk involved, so let's walk through each of those reasons and think about why I'd rather not be patient, I'd rather not wait to get the money later. Okay the first is that opportunity cost that we talked about that what could I have done with that $100 if you gave it to me today. Well if you gave that money to me today I can put it in the stock market, I could buy real estate, I can pay my electric bill, I can go out and eat at a restaurant there's lots of things that I can do with that money If I had it now. You want to tell me to wait five years for that money, I might say, okay, but I have to give something up. Any time I make a choice that involves one thing versus another, in economics, we call that an opportunity cost. Which means what I gave up by chosing between the two things. In five years from now, I've got to give something else up if you want me to be patient, that involves an Opportunity Cost. Every choice in economics involves an opportunity cost. In the case of today versus tomorrow, that opportunity cost is really time. What am I giving up? I'm giving up patience. You want me to be patient by waiting five years to get the $100. I'm uneasy, I'm uncomfortable. I'm not willing to be patient, I'd rather not. I'd rather have the money today because I could do something with it today. And the other reason that I'm not willing to wait five years is that, on average, in most economies over time, prices tend to rise over time. Which means that if I was going to go to the store and buy a candy bar and a loaf of bread, if I waited five years, to get the money to do that. I probably wouldn't be able to buy as many candy bars or as many loaves of bread at the store because their prices would have gone up over time. Inflation tends to wear away at the value of money and that means I'd rather have the money today so I could buy more candy bars and loaves of bread. Okay, since things become less valuable over time that makes me not want to be patient. That makes me say, I'm uncomfortable, I'd rather have the money today. I won't be able to buy as much in the future as I can today. The third and maybe the most important reason, is that I don't know what's going to happen between now and five years from now. Anything could happen. I don't know where I'm going to be five years from now, I don't know whether you're going to show up with money five years from now. I'm wondering are you even going to be there? Is the money going to, you know, what could happen? I might move to Timbuktu and join the circus. Lots of different things could happen between now and five years from now. I really don't know, that involves risk. So, the fact that I don't know what's going to happen means if you want to ask me to be patient, you're asking me to take risk. You're asking me to face the uncertainty of what could happen between now and five years from now in ways that I can't even model, or I can't comprehend, or I can't understand. That sounds risky to me and it makes me less comfortable being patient. Greater risk makes me less comfortable being patient which makes me want more compensation if you want me to be patient. I'll be patient, but you've gotta compensate. You've gotta pay me something. At some point, I'm probably not willing to wait under any circumstances if things are just way too risky I'll say forget it. I just want the money now. Okay, but if I made you that offer, at some point you're probably willing to be patient. What is that patience worth? If we haggle over it and come to a price and I can get you to be patient and wait to take that money later, what you charge for being patient, that price for time is what we call an interest rate. And that's where interest rates come from. They come from that basic human nature of I'd rather have stuff today, because of opportunity costs, inflation, and risk, I'd rather not wait. But that interest rate in the economy is coming from something deep about human nature. Deep about my willingness or unwillingness to be patient over time. Doesn't come from the fed, it doesn't come from the government. Interest rates come from the very human nature of our way we interact, the way we make decisions over time. That's where interest rates come from. Now at some point, I can make you a different deal. If instead of saying a $100 today versus $100 five years from now, what if I put a little extra money in them in deal? What if I said, well, I'll give you an extra dollar, if you're willing to be patient or if I said, what if I'll give you an extra $10, I'll give you $110 five years from now? That's still, you still don't like that, you're still not comfortable. What if I can in $200? $200, to wait five years. At some point, you might say, all right, that's a good deal. If you're going to double my money five years from now, I'll wait five years. I can wait five years for $200. Once we've haggled over that bargain and we come to a price that we're both, I'm willing to pay the 200, you're willing to take the 200. Once we've come to that price. That we've haggled over, at some point you'll accept the deal and once you've accepted the deal we've put a price on something, what have we put a price on? Time, once we put a price on time, that's the interest rate, that's what an interest rate really means. An interest rate is really a price on your willingness to be patient, it's a price on time. In the real world, what makes interest rates change? When we look at interest rates, we see interest rates in London, interest rates in New York, and U.S. Treasury rates, and rates on Greek debt. All of these different interest rates throughout the world economy and they're all changing all the time. What kinds of things make interest rates change? Well exactly the three things that we've talked about in first part of this lecture. Changes in opportunity costs, that are economic growth or tougher economic times make interest rates change. Changes in inflation expectations. If the government prints more money that the values how much I can buy in the future which makes interest rates rise. Risk, If I think about when interest rates tend to spike up, it's often during times of war, plague, famine, pestilence, disasters, interest rates spike up. Interest rates tend to soften or go down over periods of long peace time. So changes in opportunity costs, inflation and risk are the main drivers for why we see interest rates different in different places in the world economy. And what makes them fluctuate and wiggle overtime. All of these things are constantly changing so when we see interest rates in the real world we're looking at the changes in real time in the supply and demand of capital base on changes in opportunity costs inflation and risk, all right. To sum up our discussion of interest rates. Interest rates are the most important price in the economy because they set the floor, or the foundation, for all other prices through the economy. Once we've put a price on time, we can put a price on anything that depends on time. For example, a manufacturing process where I take inputs and change them into some output later. Anytime I'm using economic decisions that start at one point and time and end at a different point of time, they're going to ultimately depend on interest rates. Once we've put a price on time, we can think about pricing everything else in the economy. So interest rates really are one of the most important prices in economics.
