The nature of interest

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Clive Mphambela

“A DOLLAR today is worth more tomorrow” is a simple quotation that fortunately means exactly what it says.

Money, as we have understood it in my last three articles, assumes its value today from various properties based on its roles, form and function.

We have agreed that money in terms of form and function is any commodity or item that assumes an acceptable social and economic value for it to be useful as a medium of exchange, an acceptable and stable store of value, a means to settle future claims or debts and as a unit of measure or account.

We also learnt that these are not qualities that money assumes by itself, but are granted and influenced by a combination of factors, some controlled by society as a collective whole and others by the governments or the issuing authorities for such currency. We noted how inflation erodes the value of money over time, making a dollar earned tomorrow worth less than a dollar today.

So what incentive did society invent to encourage saving in the economy? If keeping a dollar under one’s mattress means that potentially due to inflation, that dollar will buy fewer goods and services in future, why not just spend it today?

These were important questions and the reason why one of the most important properties of “good” money is that it must be a good standard of deferred payment. In other words one must be able to keep money safe enough from destruction in order to settle future claims or debts or to purchase goods.

However, due to the fact that inflation is a normal part of our financial lives, we have to protect our money from erosion of value.

Holding onto money today for spending at a future date imposes a latent cost in the sense than dollar will buy less in future that it buys today. So the act of holding money or deferring its consumption today, which we call saving, means that we must somehow be compensated for deciding to spend in future.

This is how the concept of paying interest came about. If you recall, we said banking evolved out of savers (depositors of gold and silver) placing their gold with gold smiths who later realised they had hordes of gold money which could be lent at a fee to other merchants who wanted to increase their trade.

These early bankers also realised that to encourage savers to keep as much “idle” gold with them they had to pay an inducement or fee. This fee on the savers is called interest. The fee levied to the borrowers was a form of rent and called interest.

Interest is therefore a rental amount payable for the temporary use of a fixed amount of money for a given period of time.

In the hands of savers, interest is compensation for incentivising those who want to save by delaying or deferring consumption to a future date. We see therefore that interest rates serve a dual purpose, one of which is to compensate savers and another role which is that of imposing a cost on borrowers.

What then is the role of inflation in creating the need for compensation for delayed use of one’s money?

In theory a person can hold his money in a tin can for a year and spend it next year. If the rate of inflation is say 5%, a dollar today will be worth approximately 95 cents in a year’s time. So the cost of not spending a dollar today will be the 5% erosion of value that occurs.

Deferring use of one’s money from today to a future date therefore implies the saver loses the opportunity to use his or her money today. This opportunity cost encompasses any other use to which the money could have been put to today, including lending to others, investing it elsewhere, simply spending the money on current goods and services. Consumers generally prefer their consumption sooner rather than later.

Interest will therefore be a premium for the delay in consumption. The concept of opportunity costs means that the saver may not want to consume his money today, but instead would want to invest in another way. The possible gain from doing something else with the money is the opportunity cost.

Since the saver or lender will be effectively deferring consumption, they must, as a bare minimum, recover enough to compensate them for the increased cost of goods in a year due to inflation.

However, it is important for us to be aware that an interest rate which is only equal to the rate of inflation will leave the saver in the same position they would be if they had used their money today.

However, because consumers prefer consumption today rather than later, so charging interest equal only to inflation will only leave the savers with the same purchasing power so it is not adequate.

The concept of interest therefore ensures that money preserves its properties or qualities as a reasonable store of value and therefore an acceptable standard of deferred payment by compensating holders of money for deferring consumption and loss of value over time due to inflation.

In the next articles, we will explain different types of “interest rates” and illustrate how interest rates are determined from a banking point of view.

Clive Mphambela is a Banker. He writes in his capacity as advocacy officer for the Bankers’ Association of Zimbabwe. For your valuable comments and feedback related to this article, he can be reached on 04-744686, 0772206913, or clive@baz.org.zw.