## Tuesday, September 18, 2012

### Interest Rates and Monetary Policy (part 1, of many) With the Fed's resumption of the task of trying to do it's job, I figured I'd get around to a piece on interest rates and monetary policy I've been putting off for a while. Here goes.

The interest rate is a price like any other; it is the price of present consumption in terms of future consumption.  Say you start out with \$200. You have the option of consuming the entire \$200 today, or delaying consumption until a later date in order to consume more. The tradeoff is given by the equation:
Future Value of consumption  = Present Value of consumption * (1 + r) ^ t  where r is the real interest rate and t is the amount of time consumption is delayed. So \$200 delayed at a real interest rate of 5% for 10 years would be: \$200 * (1+0.05) ^ 10 = \$325.78. The higher the interest rate and the longer the time defered, the greater the consumption to be had in the future.

The point of this is that the real interest rate is an actual price, the kind settled by good ol' fashion supply-and demand, where supply and demand are the supply of deferred consumption and the demand for purchasing power immediately, as illuistrated by the following diagram to the right.

The tradeoff  between consumption today and consumption tomorrow can be illustrated by the indifference curve to the left. Any point on the curve represents a combination of present and future consumption that maximizes utility for the individual, with the actual combination being point where the curve intersects the budget line.