164 Part 3 Financial Assets
to Mr. Crusoe would constitute savings, these savings would be invested in the
! shnet, and the extra! sh the net produced would constitute a return on the
investment.
Obviously, the more productive Mr. Crusoe thought the new! shnet would be,
the more he could afford to offer potential investors for their savings. In this example,
we assume that Mr. Crusoe thought he would be able to pay (and thus he offered) a
100% rate of return—he offered to give back two! sh for every one he received. He
might have tried to attract savings for less—for example, he might have offered only
1.5! sh per day next year for every one he received this year, which would represent
a 50% rate of return to Ms. Robinson and the other potential savers.
How attractive Mr. Crusoe’s offer appeared to a potential saver would de-
pend in large part on the saver ’s time preference for consumption. For example,
Ms. Robinson might be thinking of retirement, and she might be willing to trade
! sh today for! sh in the future on a one-for-one basis. On the other hand,
Mr. Friday might have a wife and several young children and need his current
! sh; so he might be unwilling to “lend” a! sh today for anything less than three
! sh next year. Mr. Friday would be said to have a high time preference for current
consumption; Ms. Robinson, a low time preference. Note also that if the entire
population was living right at the subsistence level, time preferences for current
consumption would necessarily be high, aggregate savings would be low, interest
rates would be high, and capital formation would be dif! cult.
The risk inherent in the! shnet project (and thus in Mr. Crusoe’s ability to
repay the loan) also affects the return that investors require: The higher the per-
ceived risk, the higher the required rate of return. Also, in a more complex society,
there are many businesses like Mr. Crusoe’s, many goods other than! sh, and
many savers like Ms. Robinson and Mr. Friday. Therefore, people use money as a
medium of exchange rather than barter with! sh. When money is used, its value
in the future, which is affected by in! ation, comes into play: The higher the ex-
pected rate of in" ation, the larger the required dollar return. We discuss this point
in detail later in the chapter.
Thus, we see that the interest rate paid to savers depends (1) on the rate of return that
producers expect to earn on invested capital, (2) on savers’ time preferences for current
versus future consumption, (3) on the riskiness of the loan, and (4) on the expected future
rate of in! ation. Producers’ expected returns on their business investments set an
upper limit to how much they can pay for savings, while consumers’ time prefer-
ences for consumption establish how much consumption they are willing to defer
and, hence, how much they will save at different interest rates.^1 Higher risk and
higher in" ation also lead to higher interest rates.SELF^ TEST What is the price paid to borrow debt capital called?
What are the two items whose sum is the cost of equity?
What four fundamental factors a! ect the cost of money?(^1) The term producers is too narrow. A better word might be borrowers, which would include corporations, home
purchasers, people borrowing to go to college, and even people borrowing to buy autos or to pay for vacations.
Also, the wealth of a society and its demographics in! uence its people’s ability to save and thus their time prefer-
ences for current versus future consumption.