JAMES P WESTON: Hi, everyone. Welcome to Finance for Non-Finance Professionals, week 1, lecture 1. 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 $100 in five years from today. OK. Which would you rather have? If you ask almost anyone, anywhere in the world, children, middle-aged people, old people, anywhere in the world, they will 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 of 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. OK. 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 give that money to me today, I could put it in the stock market, I could buy real estate, I could pay my electric bill, I could go out and eat at a restaurant. There's lots of things that I could do with that money if I had it now. You want to tell me to wait five years for that money. I might say, OK, 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 choosing 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. 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 money today, so I could buy more candy bars and loaves of bread. OK. 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 the money five years from now. I'm wondering, are you even going to be there? 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. And 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 got to compensate me, you've got to 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. OK. 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, 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. It doesn't come from the Fed. It doesn't come from the government. Interest rates come from the very human nature of the way we interact, the way we make decisions over time. That's where interest rates come from. Now, at some point, I could make you a different deal. If instead of saying $100 today vs. $100 five years from now, what if I put a little extra money in the 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. You still don't like that? You're still not comfortable? What if I give you $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've 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? Why do we see, when we look at interest rates, we see interest rates in London and interest rates in New York and US 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 the first part of this lecture. Changes in opportunity costs, better economic growth or tougher economic times make interest rates change. Changes in inflation expectations, if the government prints more money, that devalues 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 cost, 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 over time. 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 based 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. Any time I'm using economic decisions that start at one point in time and end at a different point in 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.
