We're talking about the theory of debt and

interest rates.
So I want to talk about a number of
technical topics first.
going to start with a model
an Irving Fisher model of of interest.
And then I'm going to talk about present
values and discount
bonds, compound interest, conventional
bonds the term structure of
interest rates, and forward rates, these
are all technical things.
And then I want to get back and think
about what really goes on in debt markets.
So anyway, what we're talking about today
is interest rates.
the, the percent that you earn on a loan
or that you
pay on a loan depending on what side of it
you are.
And interest rates go back thousands of
years, it's an old idea.
[COUGH] typically, it's a few percent a
year, right?
[SOUND] the first question we want to try
to think about is, what explains that?
Why, why is it a few percent a year?
And why not something completely
different?
So the and why is it even a positive
number?
You, you ever think of negative interest
rate?
well, these are basic questions, so I want
to start with a history of thought.
And,
and economist from the 19th century, Eugen
Von Bohm-Bawerk,
who wrote a book on the theory of
interest, in
the late 19th century.
Actually it was
1884.
And he, has a long,
very verbose account of what causes
interest rates.
But basically he came up with three
explanations.
Why is the interest rate something like 5%
or 3% or 7% or
something in that range?
And he said, there's really three causes.
One of them is technical progress, that as
the economy gets
more and more scientific information about
how
to do things, things get more productive.
So maybe the 3% is, or the 5%, whatever it
is, is the rate of technical progress.
That's how fast, how fast technology is

improving.
But that's not the only cause that
Bohm-Bawerk talked about.
Another one was advantages
to roundaboutness.
That must be some translation from his
German but the idea is that more
roundabout production is more productive.
This isn't technical progress.
But you know, if someone can ask you
to make something directly right now,
You've gotta use
the simplest and the most direct way to do
it if you're going to do it right now.
But if you have time,
you can do a more roundabout way.
You can make tools first and do something
else
that makes you a more efficient producer
of this.
And so maybe the interest rate is
a measure of the advantages to
roundaboutness.
And the third cause that Bohm-Bawerk gave
is time preference.
That people just prefer the present over
the future, they're impatient.
This is behavioral economics, I suppose.
This is psychology that you know, you've
got a box of candy sitting there And
you're looking at it and you're saying,
well, I should really enjoy that next
year.
I believe it would spoil by next year,
next month.
But, somehow you don't, you have an
impulse to consume now.
So maybe the rate of interest is the rate
of time preference.
That maybe people are, you know, why is
the interest rate 5%?
It's because people are 5% happier to get
something now than to get it in the
future.
So he left that, train of thought for us.
This was not
mathematical economics.
It was, literary economics.
So
well, what your author, your textbook
author, Fabozzi emphasizes for
a theory of interest is something that
came from Fisher, but very simple.
And he says, the interest rate, this is
Fabozzi 's distillation
of Irving Fisher.
[SOUND] The interest rate is the
intersection of a supply and demand curve
for savings.
So I'm going to put saving, S, on this

axis and on
this axis I'm going to put the interest
rate, call that r.
I don't know why we commonly use r for
interest.
It's, it's not the first letter, it's in
the middle of the word.
And, the idea is that there's a supply of
saving in an
innate time, that people then wish to put
in the bank or
some place else to, earn interest.
And the theory is that the higher the
interest rate, the more people will save.
So we have an upward sloping supply curve.
Now, this s means supply.
Whereas this S down here means saving.
Okay?
And then there's a demand for investment
capital.
Right?
The bank lends
out your saving to, businesses.
And the businesses want to know what the
interest rate is.
The lower the interest rate, the more
they'll demand.
So we have a demand curve for saving
and then, the intersection of the two is
the interest rate.
Well, it gives the interest rate on this
axis and the amount of
saving on the other axis.
That's a very simple story.
And that's what Fabozzi covers in your
text.
But I wanted to go back to another diagram
that Fabozzi et
al did not include in their textbook.
But it also comes from the 1930 book,
Theory of interest.
and, that,
that is a diagram that shows a two period
story.
And the thing I like about this two period
diagram is that it, brings out
the Bohm-Bawerk causes of interest rate,
in a very succinct way.
So this is the second Irving-Fisher
diagram.
and, I'm going to do a little
storytelling about this, you remember the
book Robinson Caruso?
Was written by Jonathan Swift in the
1700s.
It was the story of a man named Robinson
Crusoe who
was marooned on an island all by himself,
and had to live
on his own with no help.

This is a famous story, you call it a

Robinson Crusoe economy.
There's only one person in the economy.
So of course, there's no trade.
But we'll move to a little bit of trade.
I'm just telling you a story of the rate
of,
there'll be a rate of interest on Robinson
Crusoe's island, okay?
So so here is,
I'm going to show here
consumption, today and
on this axis, consumption
next year.
All right.
And this, I don't know what I don't
remember the novel, I prob.
Did anyone here read it?
You must've
read, somebody must've read Robinson
Crusoe.
But I'm not going to be true to the story.
The story that I'm going to tell is that
Robinson Crusoe has some food.
That's all that, the whole economy, let's
say it's grain.
I don't know how he got that on the
island.
But he's got grain.
And deciding how much to eat this year and
how much to plant for next year.
So the total
amount of grain he has is right here okay,
so that is his endowment of grain.
And he could eat, that's the maximum he
could eat.
But if he eats it all, there won't be any
grain to plant for next year, okay?
So he better not eat it all or he'll
starve next year.
now, in a simple linear production eq
with,
with, tech, technology that's linear, he
can choose
to set aside a certain amount of grain.
Which is the difference between what he
has and what
he's consuming and then that will produce
grain next period.
So I'm going to draw a straight line
That's supposed to be a straight line.
These are all supposed to be straight
lines here.
Okay.
Okay.
And that is, is
trisect under linear technology.
I'm drawing it
with no, no decreasing returns.
The

idea is that for every

bushel of grain that he plants, he gets
two bushels next year or whatever
it is, okay?
And so, if, if he were to consume nothing
this period, he would have, if that's,
if I drew this thing with the right slope
of minus two you would have twice as much.
This is the maximum he could have next
period, okay?
And so he could consume anywhere along
this point, this line okay?
The, the and this would be the
simplest Robinson Crusoe economy.
Now in fact, so, so what he do?
Remember from elementary micro theory, he
has
indifference curves between consumption
today and consumption tomorrow.
Remember these?
This are like contours of his utility, we
typically draw them like this, okay?
So what does he do?
He maximizes his utility and chooses a
point.
That, with the highest indifference
curve touching the production possibility
frontier.
This is the PPF, the production
possibility frontier.
And that determines the amount that he
consumes, and, and the amount that he
saves.
So he consumes this amount here and the
difference
between his endowment and his consumption
is his savings.
And then the next period he consumes this
amount.
All right, that's simple micro theory
that's familiar to you.
now, so in this case, the interest rate,
the slope of this line, the slope
is equal to minus 1 plus r, where r is the
interest rate.
Okay?
So in this case, I have told a very simple
story.
It has only one Bohm-Bawker cause, it's
roundaboutness.
But maybe maybe there's technical
progress, too I
don't know, it has maybe a couple those
causes.
If, as time goes by, Robinson Crusoe
figures out
better how to grow grain, there could be a
technical
progress component.
But preferences don't matter in this

story, right?
Preferences I represented by his
indifference curves and since I've
got a linear production possibility
frontier im, impatience doesn't matter.
The interest rate, in this case, is
decided
by the technology, the slope of the curve.
So, we don't have of
Bohm-Bawerk's causes yet.
Okay.
Next step, that was, that was the simplest
Irving Fisher story.
The next step is let's suppose, however,
that
there are diminishing returns to
investment in grain.
All right, that means, for example, maybe
when he grows
a little bit of it, he's very good at it.
And he does, produces a big crop, but as
he tries to grow
more grain he gets less productive.
Maybe he has to do it on the worse land or
he's running out of water or something is
not going right.
Then we would change the production
possibility frontier so that it's
concave down, okay?
Something like that.
You see what I'm saying?
Diminishing returns to investment.
It is as
you keep trying to add more and more green
to your production, as you
save more and more, you get less and less
return.
So now we have a new production
possibility frontier that, that that is
more complicated.
So now what happens?
Suppose, forget this, this straight line
which I drew first and
now consider a new production possibility
frontier that's curved downward.
Well, what does Robinson Crusoe do?
Well, Robinson Crusoe picks the highest
indifference curve, right?
That touches the new, this production
possibility frontier.
So that means he finds an indifference
curve
that's tangent to it and he chooses that
point.
Okay?
Now, okay do you see?
So this is what Robinson Crusoe would do.
Now, the interest rate is the slope of the
tangency between the indifference curve
and the production possibility frontier.

It's the same for both.

And this was the insight that Bohm-Bawerk
maybe had a little trouble getting.
There's two different things
determining the interest rate.
One of them is the production possibility
frontier
and the other one is the indifference
curves.
Now, it's, we have all of Bohm-Bawerk's
causes.
We've got roundaboutness, we have
technical progress and we have impatience.
Well, the impatience would be reflected by
the slope of the, of the indifference
curves.
Now I wanted to add a person to the
economy.
Just let me start all over again.
The second, there's two Robinson Crusoes,
okay, in this island.
And let's start out with autonomy.
They haven't discovered each other yet.
They're on opposite sides of the island,
okay?
they, they have the same technology,
they have the same production possibility
frontier.
But they live on opposite sides of the
island and they don't trade with each
other.
So let me start out again.
This is the same diagram.
We have consumption today
and consumption next year, again and we
have a production possibility frontier.
That's the same curve that I drew before,
and
the technology is the same for both of
them, okay?
And then suppose they have the same
endowment.
But let's suppose that Crusoe A is very
patient
and Crusoe B is very impatient.
So, Crusoe
A, his utility, his indifference curves,
form a tangency down here.
So this is A.
And Crusoe B's indifference curves are up
here.
This is B, okay?
And so they are planning to plant
that means that Crusoe A will be saving
very little, I mean will be consuming
a lot.
Did I say A was the, A is the impatient
one, way of drawing it.
Consuming a lot now and not saving much
for the future.

But is maximizing his utility, that's why

we have
the highest indifference groups showing
here which is tangent.
And Crusoe B has picked Crusoe B is the
very patient one
and is consuming very little this year and
it plans to consume
a lot next year.
So let's say they're about to plant
according to
these tastes and then they find each
other, okay?
Now they realize there's two of us on this
island.
Now we're getting a real economy with two
people.
Okay, so what should they do?
Well the, the obvious thing is that there
are gains to trade.
And the kind of trade would be in the loan
market.
What they could do is in, you know, this
Crusoe
B is suffering a lot of diminishing
returns to production.
So, now he really shouldn't be planting so
much
grain, because he's not getting much
return for it.
Whereas this other guy on the other side
of the island has very high productivity.
He can produce a lot for a little bit of
grain.
So he should, so it's in, so tell Crusoe A
hey, you should plant some of this grain
for me.
So that, because you're get, you're,
you're
more productive, because you're not doing
as much.
Well, in a, in, in short, what, what will
happen is they won't, they'll do it
through a loan.
I will loan you so much green.
There's no money.
B wants to, A wants to consume a lot, so B
will say, I'll, instead of planting so
much
we'll strike a loan to allow you to
consume along your case.
And what will happen in the economy is
we'll
find an interest rate of the economy, that
looks something.
I'm going to draw a tangency.
Like, that's supposed to be a straight
line.
And on this tangent line, we have Crusoe B
is maximized to this utility,

subject to that tangent line constraint.

And Crusoe A
maximizes utility subject to the same
constraint.
And it has to be such a way that the
borrowing market,
as shown over here clears and when we have
that kind of equilibrium.
You can see that both A and B have
achieved higher utility than they did when
they didn't trade.
So this is the function of a lending
market, okay?
So so, A who wants to, did I say that
right?
A who wants to consume a lot this period.
The production point is here and B lends
this amount of consumption
to A, so that A can consume a lot, A can
consume this much.
And
B, since he's lent it to A, consumes only
this much this period.
But you see they're both better off.
They've both achieved a higher indiff, a
higher utility.
And what is the interest rate in the
economy?
The interest rate is the slope of this
line.
Oh well, the slope of this line is minus
one plus the interest rate.
So that is the Fisher Theory of Interest.
Then we move on to what
I said I would talk about mainly different
kinds of bonds and present values.
The, the, Irving Fisher story was very
simple
and it had only two periods, so that's
that's too simple for our purposes.
So what I want to talk about now
is, [COUGH] is different kinds of loan
instruments.
And the first and simplest is
the discount bond, okay.
When you make a loan to someone, you could
do it in the form
of a, or between a company or between a
government and someone a discount bond.
A discount bond pays a fixed amount at a
future date and it sells at a discount
today.
It pay no interest.
[COUGH] I mean it doesn't have annual
interest or anything like.
It merely specifies this bond is worth so
many
dollars or euros as of a future date.
Now why would you buy it?
Because you pay less than that amount.

So let's say that it's worth $100,

okay?
And, T periods, T years you know
there's some ambiguity about, I'll say T
Years.
[SOUND] And I made that a capital T
because
well, so what is a discount bond worth
today?
Now, we have an issue of compounding, that
I'm going to come to in a minute.
But let's assume first of all, that we're
using annual compounding and T
is in years, okay?
Then the,
the price of the discount bond
today, the price today, is equal
to $100 all over one plus r to
the T power, where T is the number of
years to maturity.
T years to maturity.
[NOISE]
Okay?
And that's that's the
formula, okay?
In other words,
1 plus r to the Tth power is equal to
100 over p.
So, 100 over p is the is the ratio of my
final value to my initial investment value
if I invest in the discount bond.
And I want to convert that to an annual
interest rate so, this is the formula
that allows me to do that.
So, r is also called yield to maturity.
The maturity is key, the time when the
discount bond matures.
So it says, if it's paying an interest
rate r once per year for T years.
And we can infer an interest rate on it,
even though it, the bond
itself has a price not an interest rate.
I mean, we can calculate the
interest rate by using this formula.
[MUSIC]