Lecture 02: Irving Fishers Impatience Theory of

Interest
This lecture discusses in greater detail Fishers impatience theory of interest.
Several concepts need to be introduced first. The financial economy is defined
by lots of people in the economy and their utilities. Remember from last lecture
that we had two kinds of people A and B with utilities given by:

UA =

1
2
log(X1 ) + log X2
3
3

(1)

UB =

1
1
log(X1 ) + log X2
2
2

(2)

People also know today what their endowments are and they have some idea
of what they are going to be tomorrow. They possess labor today and they are
going to be able to work again next year. The labor endowments were given by
A
B B
(eA
1 , e2 ) = (1, 1) for A, and (e1 , e2 ) = (1, 0) for B. The stock endowments are:
A
B
A
A
= 1, = 0, = 1/2, = 1/2.
Knowing that there are two stocks in the economy, they have to anticipate
what the dividends are going to be. As Fisher said, the main value of assets is
that they give you something, they produce a payoff. In this case they are going
to be dividends: is producing dividends of 2, and is producing a dividend
of 1 next period (e.g., D2 = 1, D2 = 2). Thus the economy consists of:
A

A
B
B

(U A, U B , (eA
1 , e2 ), (e1 , e2 ), (D2 , D2 ), , , , )

(3)

This is the beginning of the economy and we want to define from this equilibrium the following: the contemporaneous prices (q) of the stocks, the ownership
of the portfolio of stocks, and the consumption levels. At first, this appears to
be a complicated problem. We can simplify it by looking at a general equilibrium problem which is much shorter to describe. Finding a general equilibrium,
requires finding a solution for:
(q1 , q2 , , , (X1A , X2A , A , A ), (X1B , X2B , B , B ))

(4)

q1 X1i + i + i q1 ei1 + i + i

(5)

B
X1A + X1B = eA
1 + e1

(6)

X2A + X2B = eA
2 + e2 + ( + )D2 + ( + )D2

(7)

We can simplify this problem by looking at this general equilibrium:

(U A , U B , (b
eA
bA
eB
bB
1 ,e
2 ), (b
1 ,e
2 ))

(8)

A
B
where ebA
bB
1 = e1 = 1 and e
1 = e1 = 1. We find that:

1
A
A
A
ebA
2 = e2 + D2 + D2 = 1 + 1 1 + 2 = 3
2

(9)

1
B
B
B
(10)
ebB
2 = e2 + D2 + D2 = 0 + 0 1 + 2 = 1
2
Remember Fisher has no theory on contemporaneous prices, just relative
prices. Simplify the system by letting q1 = 1, which means that p1 = 1. Further,
we found that: p2 = 1/3, X1A = 4/3, X2A = 3 31 3 = 2, X1B = 2/3, X2B = 1 +
1
3 3 = 2. So we have reduced the general equilibrium to a financial equilibrium.
What are Fishers insights?

0.1

No Arbitrage

Fisher said people look through the veil of things. They understand the world
and you can count on their understanding to guide your understanding of the
economy. So if you know that = 1/3, Fisher says you dont have to solve for
the whole equilibrium to figure out what is. What would be? According
to Fisher, stock always pays off exactly what stock pays off. So if these
people are rational they are not going to allow for an arbitrage. So arbitrage
means if there are two assets or two things that are identical, they have to sell
for the same price. If they sold for a different price there would be an arbitrage.
You would sell the more expensive one and buy the cheaper one, and so you
wouldd have accomplished a perfect trade-off, but you would have gotten the
difference of money. So since = 1/3, it must be that = 2/3.
This is the first, most important principle of finance that Fisher introduced;
the idea of no arbitrage and making deductions for no arbitrage. A lot of what
we do in Finance is actually being more and more clever about how to do no
arbitrage.

0.2

Bond Pricing

Suppose we introduced a nominal bond with payoff $1 in period 2. Also suppose

1
where
for now that q1 = q2 = 1. By definition, the price of this bond is 1+i
i is the nominal interest rate. To figure out 1 + i we can use the no arbitrage
principle. Thus, 1 dollar today can go into 3 units of stock , which goes into 3
units of X2 as dividends, which equals 3 dollars. So if you take 1 dollar today
by buying stock you can get 3 units of it since its price is a 1/3, and since
stock pays one unit of output next period you know that 1 dollar today gives
you 3 units of stock alpha. In turn, this gives you 3 units of good 2 as the
output, which at a price 1 dollar tomorrow is worth 3 dollars. Therefore, by
buying stock you can put in a dollar and get out 3 dollars. So it means that
2

1 + i = 3, which means the interest rate is 200 percent. This a second result
that can be deduced.

0.3

Real Interest Rate

Fisher defined the real interest rate as number of goods today goes into number
of good tomorrow. For instance, one good today or 1 unit of X1 is 1 dollar
today. If you had one apple today you could sell it for q1 1 apple, which is
q1 1 = 1, or 1 dollar today. This one dollar today can get 3 shares or 3 units of
stock , which then gives you 3 units of X2 . Thus, 1 unit of X1 today turns into
3 units of X2 , so therefore 1 + r = 3 implies r = 200%. This is the real rate of
interest. Fisher realized that people are going to look through all the gibberish
of money and they are going to think about what apples are they giving up
today and what apples are they getting tomorrow. They are not going to be
confused by all the holding of assets in between.

0.4

Inflation

Suppose we now started with q1 = 1, q2 = 2. Fisher said that there is always a

normalization in equilibrium (in our case q1 = 1). Walras originally introduced
the idea of normalization in a one period model in general equilibrium. In
multi-period models there is a normalization every period. Every period theres
a choice of whether you are dealing with dollars, or francs, or centimes, etc.,
and so there is a free normalization.
That means that inflation 1 + g = 2/1 = 2. This means inflation will be
100%. In this case what is going to be? If we re-solved the equilibrium
taking q1 = 1 and q2 = 2 the equilibrium outcome will not be affected. Thus,
= 1/3.
This is a big question in finance. People when they were buying and selling
stocks only traded for the output produced by that stock, in our case apples.
One does not care about dollars or centimes or francs but cares about the goods
he is going to get. This is what looking through the veil means. The price of
the stock is going to stay 1/3 because the number of apples it pays tomorrow
has not changed. It is still the same one apple. Since the stock is only paying
a certain number of goods, the price of the stock today is going to equal the
present value which is 1/(1 + r) times its dividend:
= p2 D2

(11)

In essence, we got the price of the stock by saying the stock pays off one
good tomorrow, but one good tomorrow is only worth a third of one good today,
so therefore the value of the stock is only equal to a third times 1 or 1/3. So
assuming p1 is 1 you figure out how many units of todays goods is it worth.
Now, if p1 werent 1 then what do we do? Then we would have to write:
p1 = p2 D2

(12)

Therefore the following equality must hold:

=

1
1
D =
D
p1/p2 2
1+r 2

(13)

This is Fishers famous equation. Fisher said the way to figure out the value
of a stock is to look at its dividends and discount them by the real rate of
interest (i.e., 1 unit of output tomorrow, since the value of an apple tomorrow is
only a third of the value of an output today). Remember that the real interest
rate 1 + r, is equal to the ratio of the two goods. Thus, p1 / p2 is just 1 + r.
Another way of saying that is that the real interest rate is the tradeoff between
apples tomorrow and apples today which is p1 /p2. The apple tomorrow is worth
p2 times the dividend.
Therefore, the value of a stock is the real dividends it is paying in the future
discounted by the real rate of interest. You are turning tomorrows next years
goods, finding the equivalent in terms of this years goods, and the ratio of those
two prices is the real rate of interest.
Another way of saying the same thing is you could turn cash next year into
cash this year. Assuming q1 = 1, another way of saying that is:
=

1
D q2
1+i 2

(14)

q2
1
From (13) and the relation above we can write that: 1+r
= 1+i
.One takes
the nominal rate of interest times the money that is being produced, because
the nominal rate of interest gives the trade-off of a dollar today for a dollar in
the future. A dollar in the future is not worth, usually, as much as a dollar today
so you have to discount it. Hence, a certain number of dollars in the future are
worth less dollars today. If you take the payoff of dollars in the future discounted
by the nominal rate of interest you get todays price, whic would also result from
taking the real dividends in the future discounted by the real rate of interest.
Both rules are an application of the principle of no arbitrage, looking through
the veil.
So what would the nominal interest rate be in this case? Because the real
interest rate hasnt changed, it is still 200%. Since D2 = 1, q2 = 2, and = 1/3
then:

1+i=

1
D q2
2

(15)

which means that 1 + i = 6 or that i = 500%. In words, you take 1 dollar

today at price q1 = 1 that buys 3 units of alpha still, and that tells you that you
get 3 units of X2 , the dividend. The 3 units of pay 1 apple each, or 3 apples,
which in period 2 are worth 32 or 6 dollars tomorrow. Basically, we have turned
1 dollar today into 6 dollars in the future. The relationship between the nominal
and real rate of interest and inflation is the so-called Fisher Equation. These
two famous equations are called the Fundamental Theorem of Asset Pricing.

Real Rate
1 + i Nominal rate
1+r =
(16)
1 + g Inflation
So why is this theorem true? The real rate of interest trades off apples
today for apples tomorrow, and as we had, 1 apple today is trading for 3 apples
tomorrow. That is why r was 200%. Inflation is 100% and since 1 apple today
at a price of $1 is worth 3 apples or 6 dollars in the future the nominal rate of
interest has to equal 500%. We can see the principle of no arbitrage at work.
Any banker can take a dollar, buy a stock, turn it into 3 units of dividends and
then sell it for 2 dollars apiece and get 6 dollars. And so a banker can take a
dollar and turn it to 6, so competition will force the bankers to give you 6 dollars
for every 1 dollar you give. So the interest rate has to be 1 + i = 2 3 = 6 and
the real rate of interest is the nominal rate of interest divided by inflation.

0.5

An Example

Lets go back to the equilibrium with q1 = 1 and q2 = 1. Suppose China offered

to lend money to the U.S. at a 0% interest. Would that be a great deal? Would
people rush to do that? Obviously, since borrowing in the U.S economy from
another American would require paying a 200% interest, everyone would rush
to take advantage of the low interest rate.
Lets try another question. Suppose you invented a new technology that
turns 1 unit, 1 apple today, into 2 apples tomorrow. Is this something people
would rush to do or not? Could this new technology be used to make a Pareto
improvement and make everybody better off? The answer is no, because the
real prices, Fisher would say, are 1 and 1/3 and no matter how you look at it
the interest rate is 200%% you would be losing money, because you are giving
something up that is worth 1 and getting something thats only worth 2/3.
The proof is that if it did offer a Pareto improvement, and if in the end it
e A, X
e A ,X
eB, X
e B ) that made everyone better off. Then,
led to an allocation (X
1
2
1
1
A
e A + p2 X
e A > p 1 eA
it would mean that p1 X
1 + p2 e2 . Or similarly it would imply
1
2
B
B
B
B
e
e
that, p1 X1 + p2 X2 > p1 e1 + p2 e2 .
This would be the case because in this Fisher economy, if this allocation
really made A better off than what hes gotten (4/3, 2), he would have chosen
it. And B would have chosen the new allocation if it was better than (2/3,2). So
clearly they must have been too expensive for A and B to choose because they
were rationally choosing the right thing given what they could afford. You would
find that total consumption value was bigger than total endowment value which
is impossible. This is a contradiction because in the end the total consumption
of the people has to be the total of what there is available and what is produced
in the economy.
So thats how we know that no new technology could possibly make everybody better off, and we know trivially it makes everyone better off if and only
if it makes a profit. So if and only if it makes a profit can it be used to make
everybody better off, and amazingly, in a free market economy, people are going
to use it if and only if it makes a profit. So theyre going to use it if and only if
5

its a good thing for the economy. So thats the basic laissez-faire argumentthat
there are new discoveries all the time. Every other day somebodys thinking of
something new. Are we going to use it? Should we use it? Is it something we
need to read about in the papers and use? Well, there are a whole bunch of people, the discoverers themselves they are going to talk to their business friends,
and theyre going to say, Do you want to lend me the money to get this thing
going, and all of them are going to do this profit calculation. If they decide it
loses money theyre not going to do it. This is the main lesson of laissez-faire.
So let me just put this in perspective a little bit. In the old Russian economy
of the 1930s and 40s there was no profit system, so the central planner had to
figure out, should a new invention be used or not. So every time there was a
new invention a committee had to get together, of central planners and decide
whether to use it or not. There was a famous guy named Kantorovich who was
in charge of a lot of that. He won the Nobel Prize in economics. He shared
it with a Yale economist named Koopmans and so Kantorovich told this very
amusing story.
He said that there were two central planning bureaus. One was in charge
of allocations and one was in charge of prices. One had to set the prices. The
other had to set the allocations. And of course the whole message here is that
you have to combine these. You dont know whether its worthwhile to change
the allocation until you know whether the new technology is going to make a
profit or not, and here they had the two things separated. They were telling
people what to do before knowing whether they made a profit or not because
they didnt have prices because there werent free markets.
So the bottom line of the Fisher story is that you take a complicated financial
economy, you reduce it to something very simple, solve for the equilibirum, and
you can understand a lot about this economy. That is something that most
people did not realize at the time and still dont realize it now. If you ask a
typical person if there is inflation, that means the dividends next year are going
to be higher, is that going to raise the value of the stock today? One might say,
Yes of course because it makes the price of the dividends higher tomorrow.
Fisher would say no, it doesnt change anything real in the economy. If there
is more inflation there will be a higher nominal interest rate, so discounted by
the higher interest rate payoffs of the stock will give you the same stock price
as before.
To summarize, how do you know that a final allocation that emerges as a
competitive equilibrium is Pareto efficient? And the argument was if you can
do betterthat means, make everybody better offthen each person, if you look
at the value of what theyre getting under the new regime it must be more
than the value of their endowments. Otherwise they would have chosen the new
regime. That means everybody would have had to pay more for this new regime
allocation than the value of their endowments. So this is more than person A
and person B can afford. Their consumption would be more than the value of
their endowments but people can only eat what is being produced. Everything
that is being produced is part of somebodys endowment. So whatever the new
allocation is it has to add up to the new endowment.
6

Because the new technology loses money the value of the new endowment
will be lower than the value of the old endowment. The contradiction is the
value of the new endowment after the technology is used, at the old equilibrium
prices, is lower than the value of the old endowment at the old equilibrium
prices. Hence, you cannot make everybody better off.
The simple argument, that Ken Arrow and Gerard Debreu gave is the simplest and most important argument in all of economics. So we get as a conclusion
that, putting it another way, that owners of firms should maximize the value of
their firms, the stock market value of their firms, and they do so because if they
find some new way of producing that is going to lose money it is going to make
the stock market value go down. Remember the stock market value is just the
same calculation, the value of all the output they are producing. If they find
some way of losing money and they try to use it it willl make their stock market
value go down.

0.6

Impatience Theory of Interest

So far we havent introduced risk. When that happens things are going to
get more complicated. Fisher couldnt deal with risk. So without risk, where
everybody is anticipating the dividends in the future, that means that you can
always reduce a financial economy to a general equilibrium.
The solution to that problem with marginal utility and Pareto efficiency
tells us an enormous amount about how the stock market and everything works.
It tells us that the value of every stock is just the discounted real dividends,
discounted at the real rate of interest, or the discounted nominal payoffs, cash
flows, discounted at the nominal rate of interest.
And it tells us that the real rate of interest is the nominal rate divided by
the rate of inflation. And it tells us that its a good thing all these owners of
companies are maximizing profits or share value, which is the same thing, and
thats helping society.
All three major religions thought interest was a terrible thing. They all
thought that the nominal rate of interest should be 0. But what Fisher says is
the nominal rate of interest is irrelevant. Nobody cares about the nominal rate
of interest. They look at apples today and apples next year. The money and
stuff just gets in the way. It is the real rate of interest that you care about, and
the real rate of interest doesnt have to be positive.
The real rate of interest is obtained by solving for p1 and p2 in the general
equilibrium model above. So what would change the real rate of interest when all
you have are the utilities and the endowments? The first thing Fisher though of
was impatience. So in fact one of his most famous articles is called an Impatience
Theory of Interest, so lets call it that, Impatience Theory of Interest.
Fisher said that in his view people are impatient. Why? That means an
apple today they thought was more valuable that an apple next year. Why?
Because of the poor imagination, it was easy to think about eating the apple
today. You can just hold it in your hand and its so close, but to think about
7

eating it in a year requires some imagination. They had poor imagination, and
secondly, the second main reason is mortality. They might die between today
and next year.
So those are the two main reasons. So what does it mean? An apple next
year is not a sure thing. There is the Impatience Theory of Interest. So he said
that is why it makes sense to have this guy A as impatient because he values
the apple today more than a value tomorrow. He has a discount rate of = 1/2
say (i.e., = 31 / 23 = 1/2). However, B is not impatient because the discount
factor is 1.
Samuelson was the one who introduced the discount factor to capture Fishers
idea that the good next year, the same apple next year is not worth as much to
A as an apple this year. So suppose I change 1/2 to a 1/3. What will happen
to the real rate of interest? That makes people more impatient. This makes
them more impatient, because now they care even less about the good next
year. In the Reagan years, everybody talked about the now generation. People
were getting more impatient. So what happens to the real rate of interest when
people get more impatient? In order to get anybody to save, because they want
the stuff now, you are going to have to give them a higher real rate of interest.
We can write:
1
A
(p1 eA
1 + p 2 e2 )
1+
where is the discount. If p2 = 1 then:
X1A =

(17)

p1
(eA + 1/p1 eA
(18)
2)
1+ 1
So obviously as p1 goes down, your demand goes up or if p1 goes up the
demand goes down. So if you make smaller, that is going to raise demand
for A at the old prices. Why? If goes down it implies X1A goes up. So
this persion is demanding more now, but if hes demanding more at the old
equilibrium prices the only way to clear the market is to raise p1 . Thus, p1
must go up to clear the market.
In other words, if you care less about the future (i.e., low means you care
less about the future) to get anybody to save youre going to have to raise the
interest rate. To say it formally if we solve for equilibrium with a lower delta at
the old equilibrium prices, A would now shift and try to demand more of good
1. But if he demanded more of good 1 that would mean too much demand for
good 1, and the only way to clear the price of good 1 is to raise the price P1.
But if you raise p1 holding p2 fixed (i.e., p1 /p2 ), the interest rate has to go up.
That s Fishers Impatience Theory. That is the main determinant of interest
according to Fisher.
What is the second one? He says suppose people are more optimistic about
ei2 . Everybody thinks the worlds going to be much better next year. Were
going to have more endowments. What do you think is going to happen to
the interest rate, the real interest rate? If people thought they were going to
be richer at the old prices what would they do today for X1, demand more or
X1A =

less today? The point is theres going to be so much stuff around for people
to eat tomorrow, youve got to get them to want to eat all that extra stuff
tomorrow. So you have to give them an incentive to want to eat all that extra
stuff tomorrow, so you have to raise the interest rate, not lower it.
Now, how can you actually give a formal proof of that so you know youre
not confused? Again, at the old prices whats going to happen to the demand
for X1? At the old prices, since youre going to be so rich in the future, you
think youre just incredibly rich now, so of course youre going to consume more
today. So theres going to be more demand today and the endowment today
hasnt changed. So theres going to be more demand today with the same
endowment today, so therefore in order to clear the market today youre going
to have to raise p1 relative to p2 so the interest rate has got to go up.
In other words, if you increase the endowments tomorrow the supply today of
goods hasnt changed, but people are richer tomorrow. So clearly theyre going
to consume a higher fraction of their wealth. You tell anybody, Youre going
to be rich next year. Youre going to be worth a fortune, the normal person,
Cobb-Douglas person, is going to consume more stuff today anticipating that
he is going to be so rich tomorrow. He is going to borrow against tomorrows
wealth. And so therefore, in order to clear todays market where the supply
hasnt changed, with all these people trying eat more today you have to raise
todays price relative to tomorrow.
The third example is Fishers most famous one. Suppose you transfer money,
transfer wealth, from poor to rich. What would happen? We have to make an
extra assumption here. Fisher felt that the people who were rich were rich
because they were patient. They could charge interest and get lots of money.
So if you change wealth you take away some money from the poor. Thats
whats happened in the American economy over the last 15 or 20 years. The
rich have gotten richer and the poor are pretty much back where they were
before. So suppose the rich get rich at the expense of the poor. Whats that
going to do to the real rate of interest?
That would lower the interest rate. Theres an intuitive way of saying it
meaning that the rich, because they are patient, are probably the lenders. Now
they are even more willing to lend and so the interest rate has to go down to get
these other people to borrow. A formal way of saying it is that if you transfer
money from the poor to the rich that means the rich guys always consume a
higher proportion in the future because they are more patient. So a more patient
guy will consume more in the future. If you take away wealth from an impatient
guy and give it to a patient guy youre going to increase the size of the economy.
The economy is going to be more in the hands of the patient people, and so the
patient/impatient mix is going to change. People on average are more patient
than they were before so on average in the economy they are going to consume
less than they were of todays good.
Because youve made people, a lot of them impatient, a lot more patient,
youve increased the patient ones and decreased the impatient ones, so in balance
youre going to decrease demand today because it was the impatient ones who
wanted to eat today and the other guys were willing to wait. Now the guys
9

who arent willing to wait dont have any money. Theyre the ones doing all the
consuming today and now they cant afford to do much consuming, so youre
going to reduce consumption today. So to get the market to clear again you
have to lower the interest rate this time.
Those are the three famous conclusions of Fisher, more impatient people,
higher interest rate, more optimistic about the future, higher interest rate, transfers from the poor to the rich lower interest rate. So what happens to the stock
market in this case? Suppose people are more impatient. Does the stock market
go up or down? The answer is down because the stock market price is just the
1/(1 + r) times the dividends. So I havent told you the dividends changed, so
if the dividends are the same and the real interest rate has gone up the stock
market has gone down.
Now, suppose you transfer wealth from the poor to the rich, what is going to
happen to the stock market? Its going to go up. So what happened in the last
20 years? The rich got richer, the poor got poorer, the interest rates got lower
and lower and the stock market got higher and higher just as Fisher would have
said.
To summarize, Fishers theory of interest made sense of thousands of years
of confusion, and the main idea is that you shouldnt think of the nominal
interest. People look through all that. They look at the real rate of interest and
the real rate of interest is just the ratio of two prices just like everything else
in equilibrium, so therefore there is no such thing as a just price. The price, in
fact, that equilibrium finds is the best price is because that is the price that is
going to lead new firms and inventors to use technologies that help the economy
as opposed to hurting the economy and wasting resources. So the price that the
market finds is the just price and the real rate of interest is the right real rate
of interest provided that people are rational and see through this veil.
So, why is it that the real rate of interest is typically positive? Well, its
because people are impatient. Now Fisher said one other reason that screws up
the real rate of interest is people sometimes get confused by inflation.
As an amusing fact, he said that all contracts should be inflation indexed,
and he forced his Yale secretary and his secretaries at his company to change
their contracts and accept deals where their wage was indexed to inflation. And
of course the Great Depression happened and all of the prices collapsed, and so
all his secretaries got less money out of the deal so he wasnt too popular with
them either.
He said impatience is a fundamental attribute of human nature. As long
as people like things today rather than tomorrow there is going to be interest.
So interest is, as it were, impatience crystallized into a market rate, and the
reasons for impatience are the lack of foresight, possibility of dying and self
control etcetera.
In conclusion, those patient accumulate wealth and by waiting and lending they make production possible because the people with the good ideas are
getting the money to produce from the patient people who are willing to wait.

10