ECON 251 - Lecture 5 - Present Value Prices and the Real Rate of Interest

Lecture 5 - Present Value Prices and the Real Rate of Interest


Philosophers and theologians have railed against interest for thousands of years. But that is because they didn't understand what causes interest. Irving Fisher built a model of financial equilibrium on top of general equilibrium (GE) by introducing time and assets into the GE model. He saw that trade between apples today and apples next year is completely analogous to trade between apples and oranges today. Similarly he saw that in a world without uncertainty, assets like stocks and bonds are significant only for the dividends they pay in the future, just like an endowment of multiple goods. With these insights Fisher was able to show that he could solve his model of financial equilibrium for interest rates, present value prices, asset prices, and allocations with precisely the same techniques we used to solve for general equilibrium. He concluded that the real rate of interest is a relative price, and just like any other relative price, is determined by market participants' preferences and endowments, an insight that runs counter to the intuitions held by philosophers throughout much of human history. His theory did not explain the nominal rate of interest or inflation, but only their ratio.

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