What is fees charged by a lender to a borrower for the use of money or asset?
9.1 Introduction
The market town of Chambar in southeastern Pakistan serves as the financial centre for 2,400 farmers in surrounding villages. At the beginning of the kharif planting season in April, when the farmers sow cotton and other cash crops, they buy fertilizer and other inputs. Months have passed since they sold the last harvest, and so the only way they can buy inputs is to borrow money, promising to repay at the next harvest. Others borrow to pay for medicines or doctors. Show
But few farmers have ever walked through the shiny glass and steel doors of the JS Bank on Hyderabad Road. Instead, they visit one of approximately 60 moneylenders. If they are seeking a first-time loan, they will be questioned intensively by the moneylender, asked for references from other farmers known to the lender, and in most cases given a small trial loan as a test of creditworthiness. The lender will probably visit to investigate the condition of a farmer’s land, animals, and equipment.1 The lenders are right to be wary. If the farmer’s crop fails due to drought or lack of attention, the lender will make a loss. Unlike many financial institutions, lenders do not usually require that the farmer set aside some property or belongings—for example, some gold jewelry—that would become the lender’s property if the farmer does not repay the loan. If the would-be first-time borrower looks reliable or trustworthy enough, the farmer is offered a loan. In Chambar, this is at an average interest rate of 78% per annum. If the borrower pays the loan back in four months (the growing period of the crop prior to harvest), 100 rupees borrowed before planting is paid back as 126 rupees. But, knowing that more than half the loan applications are refused, the borrower would feel fortunate. And indeed, the borrower in Chambar would be, at least compared to some people 12,000 km away in New York, who take out short-term loans to be repaid when their next paycheck comes in. These payday loans bear interest rates ranging from 350% to 650% per annum, much higher than the legal maximum interest rate in New York (25%). In 2014, the ‘payday syndicate’ offering these loans was charged with criminal usury in the first degree.2 Given the interest rates charged, is the business of lending in Chambar or of payday loans in New York likely to be exceptionally profitable? The evidence from Chambar suggests it is not. Some of the funds lent to farmers are borrowed from commercial banks, like the JS Bank, at interest rates averaging 32% per annum, representing a cost to the moneylenders. And the costs of the extensive screening of borrowers and collection of the debts further reduces the profits made by the moneylenders. Partly as a result of the careful choices made by the moneylenders in Chambar, default is rare—fewer than one in 30 borrowers fail to repay. By contrast, default rates on loans made by commercial banks are much higher—one in three. The moneylenders’ success in avoiding default is based on their accurate assessment of the likely trustworthiness of their clients. Not everyone passes the trustworthiness tests set by the moneylenders and the payday lenders—some would-be borrowers find it impossible to get a loan. And, in Chambar and New York, some of those who do, pay much higher interest rates than others. Long before there were the employers, employees, and the unemployed that we studied in the previous unit, there were lenders and borrowers. Some of the first written records of any kind were records of debts. Differences in income between those who borrow—like the farmers in Chambar and those seeking payday loans in New York—and those who lend—like the money lenders in Chambar and the payday lenders in New York—remain an important source of economic inequality today. In this unit, we study borrowers and lenders and the workings of the market for credit. We examine the nature of the benefits that arise from lending and borrowing; we also show how the nature of credit markets can limit those benefits. Like the labour market, the credit market is essential to the functioning of a capitalist economy, and also like the labour market the credit market differs in important ways from the markets for bread, language courses, and the other goods and services studied in Unit 7. 9.2 Income, consumption, and wealthIn everyday language, terms like ‘money’, ‘wealth’, and ‘investment’ are often used loosely. We hear people say: ‘I want a job that pays good money,’ or: ‘I want to invest some money for when I retire,’ or: ‘I need to borrow some money to see me through to the end of the month.’ To understand the credit market, we need to clarify how these terms are used in economics. It turns out that, for economists, one of the trickiest things to define precisely is money. Economists like to define money in terms of what it does. They point to a number of functions that money fulfils. Some of these functions are also fulfilled by other things, but only money fulfils all these functions. We shall delve deeper into these functions in Unit 10. But at this stage, we only need to think about one function of money—money is a ‘store of value’. In simple terms, this means that anyone who has money can turn it into goods and services. When people say they want more money, what they really want is more of the goods and services that money will buy. Thus: consumption (C)Expenditure on both short-lived goods and services and long-lived goods, which are called consumer durables. See also: consumer durables.
Why are our paraphrases more precise than the original sentences? In each case, they focus on the person’s motivation. One way to show this is to note that money itself does not play a unique role in the original sentences. Thus:
In this unit, we shall postpone any further discussion of money. We first focus on consumption and investment directly in terms of goods and services, and on wealth as potential spending power. We then analyse the role of borrowing and lending in allowing us to shift spending across time. We return to the topic of what money is and does in Unit 10. WealthOne way to think about the amount of wealth that you have as a household is that it is the largest amount that you could spend without borrowing, after having paid off your debts and collected any debts owed to you—for example, if you sold your house, car, and everything you owned. incomeThe amount of labour earnings, dividends, interest, rent, and other payments (including transfers from the government) received by an economic actor, net of taxes paid, measured over a period of time, such as a year. The maximum amount that you could consume and leave your wealth unchanged. Also known as: disposable income. See also: gross income.human capitalThe stock of knowledge, skills, behavioural attributes, and personal characteristics that determine the labour productivity or labour earnings of an individual. It is part of an individual’s endowments. Investment in this through education, training, and socialization can increase the stock, and such investment is one of the sources of economic growth. See also: endowment, labour productivity.earningsWages, salaries, and other income from labour.flow variableA quantity measured per unit of time, such as annual income or hourly wage. See also: stock variable.stock variable A quantity measured at a point in time. Its units do not depend on time. See also: flow variable.disposable incomeIncome available after paying taxes and receiving transfers from the government.depreciationThe loss in value of a form of wealth that occurs either through use (wear and tear) or the passage of time (obsolescence).The term wealth is also sometimes used in a broader sense to include immaterial or intangible aspects, such as your health, skills, and ability to earn an income (your human capital). But we will use the narrower definition of material wealth in this unit since we focus on forms of wealth that can potentially be turned into spending on goods and services. IncomeIncome is the amount of money you receive over some period of time, whether from market earnings, assets that you own, or as transfers from the government. Since it is measured over a period of time (such as weekly or yearly), it is a flow variable illustrated below in Figure 9.1. Wealth is a stock variable, meaning that it has no time dimension. At any moment of time it is just there. In this unit, we only consider after-tax income, also known as disposable income. To highlight the difference between wealth and income, think of filling a bathtub, as in Figure 9.1. Wealth is the amount (stock) of water in the tub, while income is the flow of water into the tub. The inflow is measured by litres (or gallons) per minute; the stock of water is measured by litres (or gallons) at a particular moment in time.  Fullscreen Figure 9.1 Wealth, income, depreciation, and consumption: The bathtub analogy. As we have seen, some wealth takes physical forms, such as a house, or car, or office, or factory. The value of physical wealth tends to decline, either due to use or simply the passage of time. This reduction in the value of a stock of wealth over time is called depreciation. Using the bathtub analogy, depreciation is the amount of evaporation of the water. In economics, an example of depreciation is the fall in the value of a car with mileage and with age. Like income, depreciation is a flow (for example, you could measure it in dollars per year for a car or computer), but a negative one. When we take account of depreciation, we must distinguish between net income and gross income. Gross income is the flow of disposable income into the bathtub. It either adds to wealth, is used for consumption spending or is lost as depreciation. Before the income enters the bathtub, taxes are subtracted and transfers are added, such as pension payments from the government. Net interest receipts are part of the flow into the bathtub, and so are net receipts of transfers from others (such as gifts). income net of depreciationDisposable income minus depreciation. See also: disposable income, gross income, depreciation.savingWhen consumption expenditure is less than net income, saving takes place and wealth rises. See also: wealth.Income net of depreciation is the maximum amount that you could consume and leave your wealth unchanged. Consumption, saving, and investmentWater also flows out of the tub. The flow through the drain is called consumption, and it reduces wealth just as net income increases it. Measured consumption includes spending on goods that provide services over long periods of time, like screens, bicycles and cars. Where the services are provided over a very long period as for new housing, the spending is classified as investment. An individual (or household) saves when consumption is less than net income, so wealth increases. Wealth is the accumulation of past and current saving. Saving can take a number of forms, for example, in bank deposits, or in financial assets, such as shares (also known as stocks) in a company or a government bond. These are often held indirectly by investing in a pension fund. In everyday language these purchases are sometimes referred to as ‘investment’, but in economics investment means spending on capital goods that provide services over long periods of time, such as equipment or buildings. The distinction between investment and purchasing shares or bonds (sometimes called financial investment) is illustrated by a sole proprietor business. At the end of the year, the owner decides what to do with her net income. Out of the net income, she decides on her consumption expenditure for the year ahead and saves the remainder, so her wealth rises. With her savings, she could buy financial assets that provide funds to businesses or the government, such as shares or bonds. Contributions to a personal pension fund are an example of the use of savings to buy financial assets. Or, instead, she could spend on new assets such as computers to expand her business, which would be investment expenditure. To summarize: in this example, the wealth of the owner of the small business has increased. The form that the increase in wealth takes is a combination of money (bank deposits), financial assets (bonds, shares, and pension fund assets), and physical assets (computer equipment for her business). Lending and borrowingHouseholds borrow from banks, finance companies, payday lenders, or from other individuals to spend on consumer durables and nondurables and for the purchase of housing. Businesses and governments also borrow; when a household buys bonds with their savings, they are making a loan to the government (a government bond) or to a business (a corporate bond). Question 9.1 Choose the correct answer(s)Which of the following statements are correct?
Question 9.2 Choose the correct answer(s)Mr Bond has wealth of £500,000. He has a market income of £40,000 per year, on which he is taxed 30%. Mr Bond’s wealth includes some equipment, which depreciates by £5,000 every year. Based on this information, which of the following statements are correct?
9.3 Borrowing: Bringing consumption forward in timeBorrowing and lending are about shifting consumption and production over time. The moneylender offers funds to the farmer to purchase fertilizer now, to pay back after the crop matures, as long as the harvest is good. The payday borrower will be paid at the end of the month but needs to buy food now. The borrower brings some future buying power to the present. To understand borrowing and lending, we will use feasible sets and indifference curves. In Unit 4 and Unit 5, you studied how Alexei and Angela make choices between conflicting objectives, such as free time and grades or grain. They made choices from the feasible set, based on preferences described by indifference curves that represented how much they valued one objective relative to the other. Here, you will see that the same feasible set and indifference curve analysis apply to choosing between having something now and having something later. In earlier units we saw that giving up free time is a way of getting more goods, or grades, or grain. We shall see that giving up some goods to be enjoyed now will sometimes allow us to have more goods later. The opportunity cost of having more goods now is having fewer goods later. Borrowing and lending allow us to rearrange our capacity to buy goods and services across time. Borrowing allows us to buy more now but constrains us to buy less later. To see how this works, think about Julia. She can count on her family (now and in the future) to provide the bare necessities. But she would like to consume more now. She may be a payday borrower in New York City or a farmer in Chambar at planting time, or perhaps she has just graduated and needs to finance a period before her first job begins. Julia knows that, in the next period (‘later’), she will have $100 when she is paid or when the crop is sold. Julia’s situation is shown in Figure 9.2. Each point in the figure shows a given combination of Julia’s consumption beyond the bare necessities provided by her family—both now (measured on the horizontal axis) and later (measured on the vertical axis). We will use a figure like this throughout the unit, and often refer to the ‘slope’ of lines and curves that we draw. You may remember from studying geometry that, when a line slopes downwards from left to right, the slope is negative. This is logical—to get more income now (a positive change), Julia accepts less income later (a negative change). When economists talk about the ‘slope’ of the trade-off between now and later, they usually simplify things in the description by using the positive value of this number. This is called taking the absolute value of the slope. When we refer to the ‘slope’ of a line or curve in this unit, we will refer to the absolute value, and so the slope is always a positive number. You will find this is easier when you are describing the trade-off that borrowers make. Julia is not free to simply pick any combination of consumption now and later. She has to buy what she consumes over and above what her family provides. Fullscreen Figure 9.2 Borrowing, the interest rate, and the feasible set. Fullscreen Julia has nothing Julia has no money now but she knows that, in the next period, she will have $100. Given this state of affairs, her consumption now is $0 and $100 later. This point is labelled as her endowment. It is what she has now or expects to get before any other interaction, such as borrowing. Fullscreen Bringing future income to the present Assuming an interest rate of 10%, Julia could, for example, borrow $91 now and promise to pay the lender the $100 that she will have later, assuming an interest rate of 10%. Fullscreen Borrowing less At the same interest rate (10%), she could also borrow $70 to spend now, and repay $77 at the end of the year. In that case, she would have $23 to spend next year.
Fullscreen Borrowing even less At the same interest rate (10%), she could also borrow $30 to spend now, and repay $33 at the end of the year. In that case she would have $67 to spend next year. Fullscreen Julia’s feasible set By repeating these hypothetical borrowing and repayment combinations, the boundary of Julia’s feasible set—called her feasible frontier—is formed. This is shown for the assumed interest rate of 10%. Fullscreen Julia’s feasible frontier If Julia can borrow at 10%, she can move from her endowment by borrowing now and choose any combination on her feasible frontier. Fullscreen A higher interest rate If, instead of 10%, the interest rate is 78%, Julia can only borrow a maximum of $56 now. Fullscreen The feasible set The feasible set with the interest rate of 78% is the dark shaded area, while the feasible set with an interest rate of 10% is the dark shaded area plus the light shaded area. A closer look at borrowingIn Figure 9.2, Julia is at the point labelled ‘Julia’s endowment’. To consume at least something now, Julia considers taking out a loan, as shown. interest rateThe price of bringing some spending power forward in time. See also: nominal interest rate, real interest rate.If the interest rate were 10%, Julia could, for example, borrow a bit less than $91 now and promise to pay the lender the whole $100 that she will have later. Her total repayment of $100 would include the principal (how much she borrowed, namely $91) plus the interest charge ($9) at the rate r, or: And if ‘later’ means in one year from now, then the annual interest rate, r, is: You can think of the interest rate as the price of bringing some spending power forward in time. At the same interest rate (10%), Julia could also borrow $70 to spend now, and repay $77 at the end of the year, that is: In this case, she would have $23 to spend next year. Another possible combination is to borrow and spend just $30 now, which would leave Julia with $67 to spend next year, after repaying her loan. feasible frontierThe curve made of points that defines the maximum feasible quantity of one good for a given quantity of the other. See also: feasible set.All of her possible combinations of consumption now and consumption later, for example ($91, $0), ($70, $23) ($30, $67), are the points that make up the feasible frontier shown in Figure 9.2. This is the boundary of the feasible set when the interest rate is 10%. The fact that Julia can borrow means that she does not have to consume only in the later period. She can borrow now and choose any combination on her feasible frontier. But the more she consumes now, the less she can consume later. With an interest rate of r = 10%, the opportunity cost of spending one dollar now is that Julia will have to spend 1.10 = 1 + r dollars less later. marginal rate of transformation (MRT)A measure of the trade-offs a person faces in what is feasible. Given the constraints (feasible frontier) a person faces, the MRT is the quantity of some good that must be sacrificed to acquire one additional unit of another good. At any point, it is the slope of the feasible frontier. See also: feasible frontier, marginal rate of substitution.One plus the interest rate (1 + r) is the marginal rate of transformation of goods from the future to the present, because to have one unit of the good now, you have to give up 1 + r goods in the future. This is the same concept as the marginal rate of transformation of goods, grain, or grades into free time that you encountered in Units 4 and 5. A higher interest rate raises the price of bringing buying power forwardSuppose that, instead of 10%, the interest rate is 78%, the average rate paid by the farmers in Chambar. At this interest rate, Julia can now only borrow a maximum of $56, because the interest on a loan of $56 is $44, using up all $100 of her future income. Her feasible frontier therefore pivots inward and the feasible set becomes smaller. Because the price of bringing buying power forward in time has increased, the capacity to consume in the present has fallen, just as your capacity to consume grain would fall if the price of grain went up (unless you are a producer of grain). conflict of interestThe situation which arises if in order for one party to gain more from the interaction, another party must do less well.Of course, the lender will benefit from a higher interest rate (as long as the loan is repaid) so there is a conflict of interest between the borrower and the lender.
9.4 Reasons to borrow: Smoothing and impatienceconsumption smoothingActions taken by an individual, family, or other group in order to sustain their customary level of consumption. Actions include borrowing or reducing savings to offset negative shocks, such as unemployment or illness; and increasing saving or reducing debt in response to positive shocks, such as promotion or inheritance.Given the opportunities for bringing forward consumption shown by the feasible set, what will Julia choose to do? How much consumption she will bring forward depends on how impatient she is. She could be impatient for two reasons:
SmoothingThe first reason is that she would like to smooth her consumption because she enjoys an additional unit of something more when she has not already consumed a lot of it. Think about food—the first few bites of a dish are likely to be much more pleasurable than bites from your third serving. This is a fundamental psychological reality, sometimes termed the law of satiation of wants. diminishing marginal returns to consumptionThe value to the individual of an additional unit of consumption declines, the more consumption the individual has. Also known as: diminishing marginal utility.More generally, the value to the individual of an additional unit of consumption in a given period declines the more that is consumed. This is called diminishing marginal returns to consumption. You have already encountered something similar in Unit 4, when Alexei experienced diminishing marginal returns to free time. Holding his grade constant, the more free time he had, the less each additional unit was worth to him, relative to how important the grade would be. We can apply this to consumption in general. Diminishing marginal returns imply that we prefer to smooth our consumption. We would optimally choose to consume similar amounts now and later, as Figure 9.3 shows. Fullscreen Figure 9.3 Consumption smoothing: Diminishing marginal returns to consumption. Fullscreen Julia’s choices The dashed line shows the combinations of consumption now and consumption later from which Julia can choose. Fullscreen Diminishing marginal returns to consumption Julia’s indifference curve is bowed toward the origin as a consequence of diminishing marginal returns to consumption in each period. The more goods she has in the present, the less she values an additional one now relative to more in the future. The slope of the indifference curve is the marginal rate of substitution (MRS) between consumption now and consumption later. Fullscreen What choices would Julia make? The MRS at C is high (the slope of her indifference curve is steep)—Julia has little consumption now and a lot later, so diminishing marginal returns mean that she would like to move some consumption to the present. The MRS at E is low. She has a lot of consumption now and less later, so diminishing marginal returns mean that she would like to move some consumption to the future. So she will choose a point between C and E. Fullscreen MRS falls We can see that the MRS is falling as we move along the indifference curve from C to E. The slope is steeper at C than at E. Fullscreen Julia’s optimal choice Given the choice shown by the line CE, Julia will choose point F. It is on the highest attainable indifference curve. She prefers to smooth consumption between now and later. Pure impatience, or how impatient you are as a personIf Julia knows she can have two meals tomorrow but she has none today, then diminishing marginal returns to consumption could explain why she might prefer to have one meal today and one tomorrow. Note that Julia would opt for the meal now, not because she is an impatient person, but because she does not expect to be hungry in the future. She prefers to smooth her consumption of food. pure impatienceIn a situation in which a person’s endowment is the same amount of consumption this period and later, she would have this characteristic if she values an additional unit of consumption now over an additional unit later. It arises when a person is impatient to consume more now because she places less value on consumption in the future for reasons of myopia, weakness of will, or for other reasons. See also: weakness of will.But there is a different reason for preferring the good now, called pure impatience. To see whether someone is impatient as a person, we ask whether, if she initially had the same amount of the good in both periods, she would value having more of the good now more highly than more of the good later? Two reasons for pure impatience are:
We saw that Julia, who will earn $100 in the future, wants to borrow. The situation that she is in gives her a strong desire to smooth by borrowing. Think about what Julia’s indifference curve, passing through her endowment point, might look like. As shown in Figure 9.4, she has a strong preference for increasing consumption now. reservation indifference curveA curve that indicates allocations (combinations) that are as highly valued as one’s reservation option. See also: reservation option.This is called Julia’s reservation indifference curve, because it is made of all the points at which Julia would be just as well off as at her reservation position, which is her endowment with no borrowing or lending. Julia’s endowment and reservation indifference curves are similar to those of Angela, the farmer, in Unit 5. At point A, with no expenditure at all on consumption now, we assume Julia has some way of maintaining herself. Fullscreen Figure 9.4 Julia’s indifference curves. Figure 9.4 shows Julia’s indifference curves:
For any particular point in the figure, the individual’s impatience can be seen from the steepness of the indifference curve. At her endowment point—$100 later, nothing now—shown by point A, her indifference curve is very steep. Because she has nothing now, she is very impatient. It means she would be willing to give up a substantial amount of consumption later to gain a little bit of consumption now. This could be illustrated by a move from point A to A’. We define a person’s discount rate, (economists use the Greek letter rho), as the slope (remember, we take the absolute—positive—value) of the indifference curve minus one. It is a measure of impatience, namely how much Julia values an extra unit of consumption now, relative to an extra unit of consumption later. Her discount rate , which measures her impatience, depends both on her desire to smooth consumption and on her degree of pure impatience. A high discount rate means a high degree of impatience. Notice in Figure 9.4 that if Julia hypothetically had the $100 now (point B), she would be much less impatient; at B, her indifference curve is very flat, which means that she would like to have more consumption in the future and less now and would be willing to give up a dollar now, even if she got less than a dollar in return later. Not only would Julia be less impatient at point B (with $100 now) than at point A (in her initial situation of having $100 later), but she would also be better off. In Figure 9.4, the indifference curve through B is above the indifference curve through A. This is because, as a person, she has a degree of pure impatience. To see this, notice that when Julia’s utility is at the same level as when she has the $100 in the future, she must be on the same indifference curve, that is, the one going through A. You can see that on that indifference curve at B′, her consumption is much lower than $100. For the indifference curves shown in Figure 9.4, she values $100 later the same as she values half that amount now (B′ is one half of B). Question 9.3 Choose the correct answer(s)Figure 9.3 depicts Julia’s indifference curves for consumption in periods 1 (now) and 2 (later). Based on this information, which of the following statements are correct?
9.5 Borrowing allows smoothing by bringing consumption to the presentHow much will Julia borrow? If we combine Figures 9.2 and 9.3, we will have the answer. As in the other examples of a feasible set and indifference curves, Julia wishes to get to the highest possible indifference curve but is limited by her feasible frontier. The highest feasible indifference curve when the interest rate is 10% will be the one that is tangent to the feasible frontier, shown as point E in Figure 9.5. This means that Julia borrows just enough so that: We know that: Therefore: If we subtract 1 from both sides of this equation, we have: Here, Julia chooses to borrow and consume $56 and repay $62 later, leaving her $38 to consume later. Now consider how much she would borrow if she had to pay not 10%, but the 78% that was the average among the Chambar farmers. Figure 9.5 shows that, as before, finding the point of tangency between the new feasible frontier given by the 78% interest rate and one of Julia’s indifference curves, she will choose point G, meaning that she will borrow much less—$35—to consume now, paying $62 with interest, and having $38 to consume later. The higher ‘price’ of moving consumption forward in time means two things:
In the example we considered above, her consumption later does not change. But, depending on the shape of her indifference curves, it could be lower or higher. With the higher interest rate, she is less well off, so this would tend to push down her consumption later. But the higher interest rate makes it costlier to bring consumption forward, which would tend to push up her consumption later. Use the analysis in Figure 9.5 to see how Julia will choose consumption when the interest rate is 10% and when it is 78%. Fullscreen Figure 9.5 Moving consumption over time by borrowing. Fullscreen Julia’s feasible frontier Julia wishes to get to the highest indifference curve but is limited by her feasible frontier. Fullscreen Julia’s best option When the interest rate is 10%, the highest attainable indifference curve is the one that is tangent to the feasible frontier shown as point E. Fullscreen MRS and MRT At this point, MRS = MRT. Fullscreen The decision to borrow At point F, her discount rate, , exceeds r, the interest rate, so she would like to bring consumption forward in time. This means that the benefits to her of bringing some consumption forward to the present () are greater than the costs (r), so she will borrow more to finance current consumption. Similar reasoning eliminates all points except E on the feasible frontier. Fullscreen An increase in the interest rate If the interest rate at which she can borrow increases, the feasible set gets smaller. Fullscreen The effect of a higher interest rate The best Julia can do now is to borrow less ($35 instead of $56), as shown by point G. Question 9.4 Choose the correct answer(s)Figure 9.5 depicts Julia’s choice of consumptions in periods 1 and 2. She has no income in period 1 (now) and an income of $100 in period 2 (later). The current interest rate is 10%. Based on this information, which of the following statements are correct?
9.6 Storing or lending allows smoothing and moving consumption to the futureNow think about Marco, an individual otherwise identical to Julia, but facing a very different situation. Marco has wealth of $100 but does not (yet) anticipate receiving any income later. By identical, we mean that Marco’s preferences between consumption now and later are the same as Julia’s. For example, in Figure 9.4 we showed a hypothetical indifference curve for Julia if she had $100 now. This is Marco’s reservation indifference curve in Figure 9.6. Marco and Julia have the same degree of pure impatience but are in very different situations. Julia wishes to bring forward some consumption; Marco could use all of his $100 to buy goods to consume now, but as we have seen, this would probably not be the best he could do given the circumstances. In order to smooth his consumption over time, he wishes to move some consumption to the future. Marco’s options for smoothing: StoringMarco could do this by just putting some of his wealth in cash in a drawer, not spending it now, and having it later. We assume that his $100 will not be stolen and that $100 will purchase the same amount of goods now and later because there is no inflation (that is, the price level in the economy doesn’t rise). In Figure 9.6, we see that Marco’s endowment is on the horizontal axis, as he has $100 available now. His reservation indifference curve includes the point $100 on the horizontal axis. Figure 9.6 analyses Marco’s decision. The dark line shows Marco’s feasible frontier if he just ‘stores’ his wealth in cash in the drawer, and the dark shaded area shows his feasible set. The frontier shows that, for every dollar that Marco stores, he will have a dollar later—for example, if he stored $50 he could consume $50 of his wealth now and $50 later. Thus, the marginal rate of transformation (MRT) of current consumption into future consumption is just 1. Fullscreen Figure 9.6 Smoothing consumption by storing. Fullscreen Marco’s preferences Marco’s reservation indifference curve goes through his endowment. Fullscreen Marco’s preferences Indifference curves to the right of Marco’s reservation curve indicate higher levels of utility. Fullscreen Marco’s feasible frontier With storage, there is a one-to-one trade-off between consumption now and consumption later. Fullscreen Marco’s decision to store Point H on Marco’s indifference curve denotes the amount of storage that he will choose. In Figure 9.6, some part of Marco’s feasible frontier lies above and to the right of his reservation indifference curve, so he can do better by storing. If storing were the only option, he would definitely store some of his $100. In the figure we see that he stores less than half, so he ends up consuming more now than later. This means that Marco, like Julia, has some degree of pure impatience. If this were not the case, he would store half of his endowment and have the same levels of consumption now and later. Marco’s options for smoothing: LendingA better plan, if Marco could find a trustworthy borrower who would repay for sure, would be to lend some of his wealth. If he did this and could be assured of repayment of (1 + r) for every $1 lent, then he could have feasible consumption of 100 × (1 + r) later, or any of the combinations along his new feasible frontier. The light line in Figure 9.7 shows the feasible frontier when Marco lends at 20%. By lending, Marco has raised the marginal rate of transformation of current spending into future spending. With storing it was just 1. Now it is 1.2. As you can see from Figure 9.7, Marco’s feasible set is now expanded by the opportunity to lend money at interest, compared to storing the cash (putting it in his drawer). Anything that expands a person’s feasible set so that the old feasible set is entirely inside the new one must allow that person to be better off. Marco is able to reach a higher indifference curve by lending rather than storing. As we shall see in Unit 10, there are a variety of financial instruments in a contemporary economy that Marco can use to shift consumption to the future by lending—such as term deposits or bonds issued by companies or by the government. Note that, in recent years, returns of 20%, as in Figure 9.7, have been very unusual indeed. Fullscreen Figure 9.7 Smoothing consumption by storing and lending. Fullscreen Marco’s decision to lend The light line shows the feasible frontier when Marco lends at 20%. Fullscreen The effect of the decision to lend Marco is now able to reach a higher indifference curve. But how much will Marco lend? Like Julia, he will seek the highest feasible indifference curve by finding the point of tangency between the indifference curve and the feasible frontier. This is point J, at which Marco has equated his MRS between consumption now and in the future to the MRT, which is the cost of moving goods from the present to the future. In the example, the amount Marco lends does not change. But it could be lower or higher. When he lends, he is better off, so this would tend to push up his consumption now and push down his lending. But when he can earn interest, this increases his return from postponing consumption. This would tend to push up his lending and raise his consumption later. The case in the diagram assumes that these cancel out, leaving lending and consumption now unchanged.
Question 9.5 Choose the correct answer(s)Figure 9.7 depicts Marco’s choice of consumption in periods 1 (now) and 2 (later). He has $100 in period 1 and no income in period 2. Marco has two choices: he can store the money that he does not spend in period 1, or he can lend the money he does not consume at an interest rate of 20%. Based on this information, which of the following statements are correct?
9.7 Mutual gains and conflicts over their distribution in the credit marketIn the initial situation, Julia and Marco would both get $100 eventually, but time creates a difference. In the present, Marco’s wealth, narrowly defined, is $100. Julia’s wealth is zero. Marco and Julia’s indifference curves, and hence their pure impatience, are identical. They differ according to their situation, not their preferences. Marco’s reservation indifference curve is superior to Julia’s (farther away from the origin) because he has wealth now, and she has the same amount, but later. Julia borrows because she is poor in the present, unlike Marco, which is why she is more impatient than him. She wants to smooth her consumption by bringing some buying power to the present. Julia and Marco are on opposite sides of the credit marketThe fact that Marco is in exactly the opposite situation—he is looking for ways to move some consumption to the future—explains why they can mutually benefit, Marco by lending and Julia by borrowing. We are not assuming that they are borrowing and lending directly to each other. Rather, they are borrowing and lending on the same market. The solid lines in Figure 9.8 show the borrowing opportunities for Julia and lending opportunities for Marco, both measured by their feasible frontiers. The feasible frontiers of the two both have a slope of (1 + r). For Julia, the cost of moving $1 from the future to the present by borrowing is 1 + r, while for Marco the gain from moving $1 from the present to the future by lending is also 1 + r. They face the same ‘price’ of moving consumption in time, but they are moving their buying power in different directions. Remember, in this unit what we call the ‘slope’ will always be a positive number, even though the line slopes downwards. This is why Marco’s feasible frontier is uniformly outside Julia’s; he has more choices open to him than she does. Because they have identical indifference curves, we know that he will be able to enjoy a higher level of utility than Julia. Fullscreen Figure 9.8 On opposite sides of the market: An increase in the interest rate improves Marco’s welfare and reduces Julia’s. Fullscreen Julia’s feasible frontier The dark red line shows Julia’s feasible frontier when the interest rate is 20%. Fullscreen Marco’s feasible frontier The bright red line shows Marco’s feasible frontier when the interest rate is 20%. Fullscreen Effect of an interest rate rise on Julia’s frontier When the interest rate rises to 78%, Julia’s feasible set shrinks. Fullscreen Effect of an interest rate rise on Marco’s frontier When the interest rate rises to 78%, Marco’s feasible set expands. Figure 9.8 also shows the effect of an increase in the rate of interest from r = 0.20 to r = 0.78. The increase in the rate of interest makes both feasible frontiers steeper, but this:
Let’s return to how Marco differs from Julia. They have identical preferences, but:
Real and nominal interest rates: who benefits from inflation?real interest rateThe price of bringing some real spending power forward in time. See also: nominal interest rate.We have thus far referred simply to ‘the interest rate’. But in relating it so explicitly to the price of future consumption, we have implicitly been using what economists call the real interest rate—since what Julia cares about is her loss of real spending power, that is, what she can buy in the future taking account of inflation. nominal interest rateThe price of bringing some spending power (in dollars or other nominal terms) forward in time. The policy rate and the lending rate quoted by commercial banks are examples of nominal interest rates. See also: real interest rate, interest rate, Fisher equation.Fisher equationThe relation that gives the real interest rate as the difference between the nominal interest rate and expected inflation: real interest rate = nominal interest rate – expected inflation.Economists contrast this to the nominal interest rate, which is the rate that is typically actually paid on loans. When the price of goods and services is rising—that is, if there is a positive inflation rate—the nominal interest rate overstates the real interest rate. To take account of inflation when analysing borrowing and lending, we must use the real interest rate because it represents how many goods in the future one gets for the goods not consumed now. The Fisher equation, named after Irving Fisher (1867–1947), summarizes the relationship between the real and nominal interest rates, and inflation: Whether you lose or benefit from inflation depends on which side of the credit market you are on. As we have seen, Julia the borrower and Marco the lender have a conflict about the real interest rate: she benefits from a fall in the interest rate and he benefits from a rise. So they also have differing perspectives on inflation, because if prices rise before Julia repays her loan, a lender like Marco would find that he can buy less with the repayment than would have been the case if there were zero inflation. She benefits from a fall in the real interest rate because of inflation; he loses out. More precisely, the real interest rate measures the buying power of the repayment of a loan at the stipulated nominal interest rate, taking account of the prices that exist when the loan is repaid. To see what this means, let’s consider a situation in which Julia were to borrow $50 directly from Marco with a repayment of $55 next year. The nominal interest rate for this loan contract between them is 10%. But if next year’s prices were 6% higher than this year’s (6% inflation rate), then what Marco could buy with the repayment is not 10% more than he could have bought with the sum he loaned to Julia, but instead only 4%. The real interest rate is 4%. Question 9.6 Choose the correct answer(s)The following table shows the nominal interest rate and the annual inflation rate (the GDP deflator) of Japan in the period 1996–2015 (Source: World Bank).
Based on this information, which of the following statements are correct?
9.8 Borrowing may allow investing: Julia’s best hopeLike Julia in our model, payday borrowers in New York often buy groceries or clothes for their children with their borrowed funds; farmers in Chambar also often borrow for purposes of consumption, for example, to pay for a wedding. But both the Chambar farmers and New York payday borrowers sometimes use the borrowed funds for an investment. For the Pakistani farmers, this could be the purchase of equipment that would improve the crop yield. collateralAn asset that a borrower pledges to a lender as a security for a loan. If the borrower is not able to make the loan payments as promised, the lender becomes the owner of the asset.Now suppose that Julia is considering becoming a Lyft driver and to qualify needs to make some cosmetic repairs on her brother’s car that she will drive. She cannot use the car as collateral (it is not hers), so she finds it difficult to get a conventional loan. She goes to a payday lender, who, as in the example above, will charge her an interest rate of 78%. Figure 9.9 shows Julia’s feasible set and frontier based on borrowing at this rate. Julia has a new option—she can borrow and then split how much she has borrowed between consuming some now and investing the rest. This is how she does her planning:
Suppose it is the case that every dollar Julia spends on the car will result in $3 more in income next year (that is, a rate of return of 200%). With this investment, she can move along the new dashed feasible frontier. To see the full range of her new options, if she invested the entire $56 (so that she would have no consumption now), she would have $168 (3 × 56) next year. All the points on the dashed feasible frontier with investment are now open to her. The slope of the feasible frontier with investment is 3, which is the ratio of income later to amount invested. The steeper the slope is, the better for Julia. This slope is the marginal rate of transformation of current investment into future income. Fullscreen Figure 9.9 Options for the individual (Julia) who starts without assets but can borrow and invest. Fullscreen Julia’s options She can borrow at an interest rate of 78% and can also choose to invest some of her income with a return of 200%. The dotted line shows her feasible frontier when she chooses to borrow and invest.
Fullscreen How much will Julia invest? She will use the same rule that she used in deciding how much to borrow when there was no option to invest. She will find the highest feasible indifference curve by finding the tangency of an indifference curve and the feasible frontier, or what is the same thing, equating the MRT (slope of the feasible frontier) with the MRS (slope of the indifference curve.) Fullscreen Julia’s optimal choice Doing this, Julia chooses point I in the figure. How does this work out for her? Having borrowed the maximum—$56—she invests $21 and consumes $35 now. The investment of $21 will yield her an income of $63 later. The investment opportunity has greatly increased Julia’s wellbeing. She consumes the same amount now that she did when only the borrowing opportunity was available—$35—but she can now consume $63 later, rather than only $38. Note that she will only invest if she has an investment project with a rate of return higher than 78%—the rate of return has to be higher than the borrowing rate in order to expand her feasible set. In our example, Julia consumes the same amount now under the borrowing only and borrowing and investment options; her current consumption could be either greater than or less than in the case without the investment opportunity. What is certain is that she is better off with the investment opportunity because her feasible set is expanded. We can thus contrast three situations in which Julia might have found herself:
Question 9.7 Choose the correct answer(s)Figure 9.9 depicts two possible feasible frontiers for Julia, who has no income in period 1 (now) and $100 in period 2 (later). The solid line (option 1) shows her feasible frontier if she borrows at an interest rate of 78%. The dotted line shows her feasible frontier if she borrows at an interest rate of 78% and can invest for a return of 200% (option 2). Based on this information, which of the following statements are correct?
9.9 Balance sheets: Assets and liabilitiesassetAnything of value that is owned. See also: balance sheet, liability.liabilityAnything of value that is owed. See also: balance sheet, asset.net worthAssets less liabilities. See also: balance sheet, equity.insolventAn entity is this if the value of its assets is less than the value of its liabilities. See also: solvent.A balance sheet summarizes what the household, bank, or firm owns and what it owes to others. The things you own (including what you are owed by others) are called your assets, and the debts you owe others are called your liabilities (to be liable means to be responsible for something, in this case to repay your debts to others). The difference between your assets and your liabilities is called your net worth. The relationship between assets, liabilities, and net worth is shown in Figure 9.10. If the value of assets is below that of liabilities, the net worth of the entity (household, firm, or bank) is negative and it is insolvent. Fullscreen Figure 9.10 A balance sheet. When the components of an equation are such that by definition, the left-hand side is equal to the right-hand side, it is called an accounting identity, or identity for short. The balance sheet identity states: To understand the concept of net worth, which is what makes the left- and right-hand sides balance by definition, we can turn the identity around by subtracting liabilities from both sides so that: The composition of the balance sheets of banks and non-financial companies look very different. Figure 9.11 illustrates the relationship between liabilities and net worth in the case of a bank—Barclays—and a motor vehicle company, Honda. It is immediately evident that the bank is a very debt-heavy entity compared to the non-financial firm. Fullscreen Figure 9.11 Liabilities and net worth (Barclays and Honda). Balance sheets help us to understand the relationships between households and banks in the economy. Bank deposits make up part of the typical household’s assets and they appear on the liability side of the balance sheet of banks in the economy. Another typical asset of a household is its house. Unless the household owns the house outright, the household has a liability as well as an asset—the liability is the mortgage. The mortgage, in turn, is an asset of the bank. global financial crisisThis began in 2007 with the collapse of house prices in the US, leading to the fall in prices of assets based on subprime mortgages and to widespread uncertainty about the solvency of banks in the US and Europe, which had borrowed to purchase such assets. The ramifications were felt around the world, as global trade was cut back sharply. Goverments and central banks responded aggressively with stabilization policies.In Unit 10, we return to the balance sheets of households and banks in the global financial crisis. For some households, when house prices fell, their assets were worth less than the mortgage (that is, their liability—what they owed on the house). Households defaulted on their mortgage payments. Many banks—with a balance sheet similar in structure to that of Barclays in Figure 9.11—were vulnerable to their net worth being ‘wiped out’ by a fall in the value of their assets. When net worth is a tiny fraction of the size of the balance sheet, a small percentage change in the value of the bank’s assets can reduce it below the unchanged value of its debts (its liabilities). Given that mortgages and other assets based on mortgages accounted for a substantial part of banks’ assets, when house prices fell and households defaulted on their mortgages, this reduced the banks’ assets and threatened to reduce the individual bank’s net worth below zero. Banks were insolvent and as we shall see, governments stepped in to bail them out. Borrowing, lending, and net worthIn the bathtub analogy in Figure 9.1, the water in the bathtub represents wealth as accumulated savings and is the same as net worth. As we saw, net worth or wealth increases with income (inflow to the bathtub), and declines with consumption and depreciation (outflow). But your wealth or net worth does not change when you lend or borrow. This is because a loan creates both an asset and a liability on your balance sheet; if you borrow money, you receive a bank deposit or cash as an asset, while the debt is an equal liability. In our example, Julia starts off with neither assets nor liabilities and a net worth of zero, but on the basis of her expected future income a bank lends her $56 at an interest rate of 10% (point E in Figure 9.5). At this time, her asset is the $56 in the bank deposit that she is holding, while her liability is the loan that she must pay back later. We record the value of the loan as $56 now, since that is what she received for getting into debt (her liability rises to $62 later only once interest has been added). This is why taking out the loan has no effect on her current net worth—the liability and the asset are equal to one another, so her net worth remains unchanged at zero. In Figure 9.12, this is recorded in her balance sheet under the heading ‘Now (before consuming)’. She then consumes the $56—it flows out through the bathtub drain, to use our earlier analogy. Since she still has the $56 liability, her net worth falls to –$56. This is recorded in Figure 9.12 in her balance sheet under the heading ‘Now (after consuming)’. Later, she receives income of $100 deposited in her bank account (an inflow to the bathtub). Also, because of the accumulated interest due, the value of her loan has risen to $62. So her net worth becomes $100 – $62 = $38. Again, we suppose that she then consumes the $38, leaving her with $62 to pay off her debt of $62. At this point, her net worth falls back to zero. The corresponding balance sheets are also shown in Figure 9.12. Now—before consuming
Net worth = $56 − $56 = $0 Now—after consuming
Net worth = −$56 Later—before consuming
Net worth = $100 − $62 = $38 Later—after consuming
Net worth = 0 Figure 9.12 Julia’s balance sheets. Question 9.8 Choose the correct answer(s)The following diagram depicts Julia’s choice of consumption in periods 1 (now) and 2 (later) when the interest rate is 78%. She has no income in period 1 and an income of $100 in period 2. Her consumption choice is shown by G. Based on this information, which of the following statements regarding Julia’s balance sheet are correct? Fullscreen Figure 9.13 Julia’s consumption choices.
9.10 Credit market constraints: Another principal–agent problemLending is riskyUp until now, we have said little about the elephant in the room—lending is a risky activity for a bank or money lender. A loan is made now and must be repaid in the future. Between now and then, unanticipated events beyond the control of the borrower can occur. If the crops in Chambar, Pakistan were destroyed by bad weather or disease, the moneylenders would not be repaid, even though the farmers worked hard. The obsolescence of the skill you have invested in using your student loan is an unavoidable risk and will mean the loan may not be repaid. The greater the risk of default due to unavoidable events, the greater the interest rate set by a bank or a moneylender. This is one explanation for why an interest rate of 78%, as is the case in Chambar, is not highly profitable. Two other reasons were noted in the introduction:
Conflicts of interest, and information problemsBut lenders face two further problems. When loans are taken out for investment projects, the lender cannot be sure that a borrower will exert enough effort to make the project succeed. Remember, if the borrower has not put any of her own money into the project, it is the lender, not the borrower, who loses money if the project fails and the loan is not repaid. Moreover, often the borrower has more information than the lender about the quality of the project and its likelihood of success. These problems arise in turn from a difference (or conflict) of interest between the borrower and lender, and from the difference between the information the borrower and the lender have about the borrower’s project and actions. The problems impose costs of monitoring and loan enforcement that will push up the interest rate on loans. If the project doesn’t succeed because the borrower made too little effort or because it just wasn’t a good project, the lender loses money. If the borrower were using only her own money, it is likely that she would have been more conscientious or maybe not engaged in the project at all. The borrower may decide to use the borrowed funds for a much riskier project than the one that she told the lender she would use it for. To illustrate this (with an extreme example), she could simply buy lottery tickets with the money she has borrowed—if one of them pays off, she is rich; if not, the lender does not get repaid. principal–agent relationshipThis is an asymmetrical relationship in which one party (the principal) benefits from some action or attribute of the other party (the agent) about which the principal’s information is not sufficient to enforce in a complete contract. See also: incomplete contract. Also known as: principal–agent problem.The relationship between the lender and the borrower is a principal–agent problem similar in many ways to the relationship between the employer and employee studied in the previous unit. The lender is the ‘principal’ and the borrower is the ‘agent’. The principal–agent problem between borrower and lender is also similar to the ‘somebody else’s money’ problem discussed in Unit 6. In that case, the manager of a firm (the agent) makes decisions about the use of the funds supplied by the firm’s owners (the principals), but they cannot contractually require the manager to act in a way that maximizes their wealth, rather than pursuing her own objectives. Incomplete contractsIn the case of borrowing and lending, it is often not possible for the lender (the principal) to write a contract that ensures a loan will be repaid by the borrower (the agent). The reason is that it is impossible for the lender to ensure by contract that the borrower will use the funds in a prudent way and repay according to the terms of the loan. The table in Figure 9.14 compares two principal–agent problems.
Figure 9.14 Principal–agent problems: The credit market and the labour market. Lenders will attempt to secure repayment of a loan through legal measures but this will often be difficult if the borrower is poor or declares bankruptcy because they are insolvent. In the introduction to this unit, we reported an example of a method of improving compliance in car loan repayments—companies install devices that disable the ignition of the car if the repayments are not made as required. If legal methods fail, lenders may use illegal ones, such as threatening physical violence. The role of collateral in lendingequityAn individual’s own investment in a project. This is recorded in an individual’s or firm’s balance sheet as net worth. See also: net worth. An entirely different use of the term is synonymous with fairness.One response of the lender to the conflict of interest in the credit market is to require the borrower to put some of her wealth into the project (this is called equity). The more of the borrower’s own money that is invested in the project, the more closely aligned her interests are with those of the lender. Another common response is to require the borrower to set aside property that will be transferred to the lender if the loan is not repaid (this is called collateral). Collateral is used in loans for houses (called mortgages) and for cars. For many people, these are the only large loans they can get, and that is because of the collateral—the house, or the car reverts to the lender if repayments are not made. The pawnbroker is a common example of collateral in small-scale lending and borrowing that has existed for thousands of years. The pawnbroker, found today on shopping streets under the slogan ‘Cash converter’ or similar, extends a loan to the borrower with a date and amount of repayment specified. And the borrower turns over some item of his or her property to the pawnbroker, which will be returned to the borrower when the loan is repaid. Items commonly lodged with a pawnbroker because they can easily be sold include jewelry, computers and other electronic equipment, cameras, or valuable household items. A loan with collateral is called a secured loan because, as long as the collateral (the house or the pawned item) can readily be sold for more than the amount of money owed, the lender is secure. With a secured loan, the lender does not run any risk. Equity or collateral reduces the conflict of interest between the borrower and the lender. The reason is that, when the borrower has some of her money (either equity or collateral) at stake:
Credit rationing and inequalitycredit rationingThe process by which those with less wealth borrow on unfavourable terms, compared to those with more wealth.credit-excludedA description of individuals who are unable to borrow on any terms. See also: credit-constrained.credit-constrainedA description of individuals who are able to borrow only on unfavourable terms. See also: credit-excluded.But there is a hitch. If the borrower had been wealthy, she could either have used her wealth as collateral and as equity in the project, or she could have been on the other side of the market, lending money. Often the reason why the borrower needs a loan is that, like Julia, she is not wealthy. As a result, she may be unable to provide enough equity or collateral to sufficiently reduce the conflict of interest and hence the risk faced by the lender, and the lender refuses to offer a loan. Adam Smith had credit rationing in mind when he wrote: ‘Money, says the proverb, makes money. When you have got a little it is often easy to get more. The great difficulty is to get that little.’ Adam Smith. 1776. ‘Of the profits of stock’. In An Inquiry into the Nature and Causes of the Wealth of Nations. This is called credit rationing—those with less wealth borrow on unfavourable terms compared with those with more wealth or are refused loans entirely. Borrowers whose limited wealth makes it impossible to get a loan at any interest rate are termed credit-excluded. Those who borrow, but only on unfavourable terms, are termed credit-constrained. Both are sometimes said to be wealth-constrained, meaning that their lack of wealth limits their credit market opportunities. The relationship between wealth and credit is summarized in Figure 9.15. Fullscreen Figure 9.15 Wealth, project quality, and credit. The exclusion of those without wealth from credit markets or their borrowing on unfavourable terms is evident in these facts:
Question 9.9 Choose the correct answer(s)Which of the following statements regarding the principal–agent problem are correct?
9.11 Inequality: Lenders, borrowers, and those excluded from credit marketsWe can analyse inequalities between borrowers and lenders (and among borrowers) using the same Lorenz curve and Gini coefficient model that we used to study inequality among employers and employees in Unit 8, and farmers and landowners in Unit 5. Lenders and borrowers in the Lorenz curve diagramHere is an illustration. An economy is composed of 90 farmers who borrow from 10 lenders and use the funds to finance the planting and tending of their crops. The harvest (on average) is sold for an amount greater than the farmer’s loan, so that for every euro borrowed and invested, the farmer receives 1 + R when the crop is sold after the harvest. This is the farmer’s revenue. Following the harvest, the farmers repay the loans with interest, at rate i. To focus on the Lorenz curve model, we simplify in this section by assuming that all of the loans are repaid and that all lenders lend the same amount to the farmers at the same interest rate. The main message would not be altered if we included the probability that loans were not repaid (as in the Chambar case study), but the mathematics would be a lot more complicated.
Thus, if i = 0.10 and R = 0.15, then the lender’s share of total income is two-thirds and the borrower’s is one-third. Inequality in this economy is shown by the dark-shaded area bordered by a solid line in Figure 9.16. The Gini coefficient is 0.57. Excluded borrowers raise the Gini coefficientIn the previous sections, we showed why some would-be borrowers (those unable to post collateral or lacking their own funds to finance a project) might be excluded entirely from borrowing even if they would be willing to pay the interest rate. How does this affect the Lorenz curve and the Gini coefficient? To explore this, imagine that 40 of the prospective borrowers are now excluded. Since they cannot borrow, they receive no income at all. For the other farmers, i and R remain unchanged. The dashed line in Figure 9.16 shows the new situation. The new Gini coefficient is 0.70, showing an increase in inequality when the poor are excluded from the credit market. Fullscreen Figure 9.16 Inequality in a borrowing and lending economy. The Gini coefficient when everyone in the population can borrow is 0.57. When 40% of would-be borrowers are excluded from the credit market, it is 0.70. Fullscreen A model economy of lenders and borrowers An economy is composed of 90 farmers who borrow from 10 lenders. Since i = 0.10 and R = 0.15, the lenders’ share of total income is two-thirds and the borrowers’ is one-third. The Gini coefficient is 0.57. Fullscreen Some borrowers are credit market excluded Suppose that 40 of the prospective borrowers are excluded. Since they cannot borrow, they receive no income at all. Fullscreen Inequality increases When some prospective borrowers are excluded, the Gini coefficient increases to 0.70. Question 9.10 Choose the correct answer(s)In an economy with a population of 100, there are 80 farmers and 20 lenders. The farmers use the funds to finance the planting and tending of their crops. The rate of profit for the harvest is 12.5%, while the interest rate charged is 10%. Compare the following two cases: Case A: All farmers are able to borrow. Case B: Only 50 farmers are able to borrow. Based on this information, which of the following statements are correct?
The credit market can provide mutual gains but perpetuates inequalitiesThis example illustrates the fact that one cause of inequality in an economy is that some people (like Marco) are in a position to profit by lending, just as others, like Bruno in Unit 5, are in a position to profit by employing others. It is sometimes said that rich people lend on terms that make them rich, while poor people borrow on terms that make them poor. Our example of Julia and Marco made it clear that one’s view of the interest rate—as a cost for Julia and as a source of income for Marco—depends on one’s wealth. People with limited wealth are credit-constrained, which limits their ability to profit from the investment opportunities that are open to those with more assets. mutual gainsAn outcome of an interaction among two or more people, in which all parties are better off as a result than they would have been without the interaction (or at least some parties are better off and none are worse off).It is also true that, in determining the rate of interest at which an individual borrows, the lender often has superior bargaining power, and so can set a rate that enables him to capture most of the mutual gains from the transaction. Banks are not the most popular or trusted institutions. In the US, for example, 73% of people expressed ‘a great deal’ or ‘quite a lot’ of confidence in the military in 2016, exactly the same as the level a decade earlier. In contrast, in 2016, only 27% expressed a degree of confidence in banks, down from 49% a decade earlier. Surveys show that the public in Germany, Spain and many other countries hold their banks in low esteem. This has particularly been the case since the financial crisis of 2008. In Unit 10, we look at banks as economic actors in a modern economy. Like other profit-making firms, banks are owned by wealthy people and they often transact on terms (rates of interest, wages) that perpetuate the lack of wealth of borrowers and employees. But as we saw in the Chambar case, the profitability of the lending also depends on the extent of competition among lenders. The interest rate charged by the moneylenders in Chambar would have been even higher if—as in many villages—there is only a single moneylender. Like the labour market, the credit market provides opportunities for mutual gainsBut even those who dislike banks do not think that the less wealthy would be better off in their absence, any more than that the less wealthy would benefit if firms ceased to employ workers. Access to credit is essential to a modern economy—including access of the less well off to economic opportunities—because it provides opportunities for mutual gains that occur when people can benefit by moving their buying power from one time period to another, either borrowing (moving it to the present) or lending (the opposite).
9.12 The credit market and the labour marketThe credit and labour markets share similarities. We use a principal–agent model to describe both.
The two markets are not only similar, they are related to each other, the credit market providing the funds allowing some (but not others) to become employers in the labour market. This is shown in Figure 9.17. Fullscreen Figure 9.17 The credit and labour markets shape the relationships between groups with different endowments. Fullscreen A model economy Consider an economy with wealthy individuals and employees. Fullscreen Credit market excluded Those without wealth (collateral) or insufficient wealth are excluded from the credit market. Fullscreen Wealthy individuals and successful borrowers These people can purchase capital goods so as to become employers. Fullscreen Those who are not wealthy These are employees or unemployed. Fullscreen Employers hire employees on the labour market This excludes the unemployed. Starting at the upper left of Figure 9.17, wealthy individuals can use their wealth to purchase the capital goods to become employers and they can also lend to others. Among the less wealthy, there will be some successful borrowers who can, as a result, also become employers. Those with even less wealth cannot borrow (they are the credit market excluded or can only borrow where the house provides the collateral for the mortgage), and must seek work as employees. Employers then hire employees from among the less wealthy, with some remaining unemployed (due to the workings of the labour market that you studied in Unit 8). Horizontal arrows (‘lend to’ and ‘hire’) indicate a principal–agent relationship. Lenders and employers are the principals in Figure 9.17; their common orange colour indicates this similarity. Agents—successful borrowers, and employees—are coloured green to distinguish them from would-be agents (credit market excluded and unemployed), who are coloured purple. You definitely do not want to be in the purple boxes. But even if you are an agent lucky enough to be in one of the green boxes, the principal can put you back in the purple box just by refusing to deal with you. This is why lenders and employers have power over borrowers and employees. Figure 9.17 helps us understand why some people end up as principals (employers, for example), while others end up as agents (employees). If one is wealthy, one can be both a lender and an employer. There is some truth to the saying that ‘people are born into their position in the economic order’. This was literally true in some economies of the past, for example, when the position of the slave was perpetuated in the slave’s children as a matter of law. If you want to study this topic in more detail, you can read about it in Unit 19 of The Economy, which is all about the causes and effects of economic inequality. Something similar can occur in places where wealth is inherited from parent to child. The children of employees (who inherit little wealth) are also more likely to become the next generation’s workers than are the children of employers. The children of well-off parents in the US also tend to have high incomes when they become adults. 9.13 ConclusionWe have explained how credit markets, like labour markets, shape the relationship between groups with different levels of wealth. To do so, we began by differentiating between wealth (a stock of accumulated savings) and income (a flow affected by direct taxes and transfers). Wealth can include money, financial assets, and physical assets. A broader definition of wealth includes human capital, seen as an asset contributing to higher labour earnings. Using the feasible set and indifference curves of our constrained choice toolkit, we have developed a model of borrowing and lending to analyse how individuals decide to allocate their consumption across time periods.
While the different situations of borrowers and lenders give rise to the possibility of mutual gains from interacting in the credit market, there is a conflict of interest over how these gains are distributed. An increased interest rate expands a lender’s feasible set but shrinks that of a borrower. The lender benefits from the repayment of the loan, which is a cost to the borrower. These conflicts of interest, along with the fact that repayment cannot be guaranteed by an enforceable contract, motivate us to model this as a principal–agent relationship in which the credit contract is incomplete: It cannot enforce a prudent use of funds and the repayment of the loan. Putting some of one’s own wealth at stake (be it as equity in a project or collateral on a loan) means that the borrower has less incentive to misuse the funds (by taking extraordinary risks, for example) and more incentive to work to make the project succeed. Individuals with limited wealth, however, may not have access to loans because they cannot provide equity or collateral, or they can only borrow at high interest rates. This credit rationing can perpetuate inequalities as it limits the ability of less wealthy people to profit from the investment opportunities that are open to those with more assets. 9.14 Doing Economics: Credit-excluded households in a developing countryIn Sections 9.10 and 9.11, we outlined the principal–agent problem in credit markets, which leads to some households being credit-constrained or credit-excluded. In Doing Economics Empirical Project 9, we will use survey data from a developing country (Ethiopia) to identify households that face credit constraints and look at how borrowing conditions vary with household characteristics. Go to Doing Economics Empirical Project 9 to work on this project.
9.15 ReferencesConsult CORE’s Fact checker for a detailed list of sources.
What is the fee charged by a lender of money to the borrower?This is due to interest and fees, which is what a lender charges you for the use of its money. It is also referred to as a finance charge. A finance charge is the dollar amount that the loan will cost you. Lenders generally charge what is known as simple interest.
What is the fee charged for a loan called?One of the more common finance charges is the interest rate. This allows the lender to make a profit, expressed as a percentage, based on the current amount that has been provided to the borrower. Interest rates can vary depending on the type of financing acquired and the borrower's creditworthiness.
What is the fee charged by a lender on money borrowed or a fee paid to an investor on his or her investment?The sum of money you deposit into a savings account or borrow from a bank is called the principal. The fee to borrow money is called interest. When you borrow money you pay back the principal and interest to your lender.
What is a finance fee?The finance charge is the cost of consumer credit as a dollar amount. It includes any charge payable directly or indirectly by the consumer and imposed directly or indirectly by the creditor as an incident to or a condition of the extension of credit.
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