Archive for the ‘Economics’ Category
What is Time Preference?
Time preference is the economist’s assumption that a consumer will place a premium on enjoyment nearer in time over more remote enjoyment. A high time preference means a person wants to spend their money now and not save it, whereas a low time preference means a person might want to save their money as well.
The time preference theory of interest is an attempt to explain interest through the demand for accelerated satisfaction. This is particularly important in microeconomics. The Austrian School sees time as the root of uncertainty within economics.
In his book Capital and Interest, the Austrian economist Eugen von Böhm-Bawerk built upon the time-preference ideas of Carl Menger, insisting that there is always a difference in value between present goods and future goods of equal quality, quantity, and form. Furthermore, the value of future goods diminishes as the length of time necessary for their completion increases.
Böhm-Bawerk cited three reasons for this difference in value. First of all, in a growing economy, the supply of goods will always be larger in the future than it is in the present. Secondly, people have a tendency to underestimate their future needs due to carelessness and shortsightedness. Finally entrepreneurs would rather initiate production with goods presently available, instead of waiting for future goods and delaying production.
Hans-Hermann Hoppe elaborates on time-preference as a gauge of the degree of civilization of a given society in his book Democracy: The God That Failed. Laws in a society in violation of property rights increase time-preference, whereas a tradition of respect for property rights decreases time-preference.
What is Business?
The term business refers to activities or interests.
By extension the word became (as recently as the 18th century) synonymous with “an individual commercial enterprise” and has also sometimes taken on the meaning of “the nexus of commercial activities” or of “the representatives of commercial activity”.
Specifically, business can refer, collectively, to individual economic entities. In some legal jurisdictions, such entities are regulated by law to conduct operations on behalf of entrepreneurs. A manufacturing business is commonly referred to as an industry: for example: the “entertainment industry”, or the “dairy industry”, or the “fishing industry”.
What is a Store of Value?
To act as a store of value, a commodity, a form of money, or financial capital must be able to be reliably saved, stored, and retrieved - and be predictably useful when it is so retrieved.
This is distinct from the standard of deferred payment function which requires acceptability to parties one owes a debt to, or the unit of account function which requires fungibility so accounts in any amount can be readily settled. It is also distinct from the medium of exchange function which requires durability when used in trade, and a minimum of opportunity to cheat others.
When currency is stable, money can serve all four functions. When it isn’t, such as during times of hyperinflation or when complex and volatile forms of financial capital are involved, it becomes important to identify alternative stores of value, of which common ones are:
- real estate - actual deeds in protectible land
- gold - once the basis of the gold standard
- silver - once the basis of the silver standard
- precious stones, and other precious metals
- more stable currencies, e.g. Swiss franc or digital gold currency
- collectibles, e.g. original art by a famous artist or antiques
- livestock (see African currency)
While these items may be inconvenient to trade daily or store, and may vary in value quite significantly, they rarely or never lose all value. This is the point of any store of value, to impose a natural risk management simply due to inherent stable demand for the underlying asset. It need not be a capital asset at all, merely have economic value that is not known to disappear even in the worst situation. In principle, this could be true of any industrial commodity, but gold and precious metals are generally favored because of their demand and rarity in nature, which reduces the risk of devaluation associated with increased production and supply.
What is Credit Money?
Credit money is any future claim against a physical or legal person that can be used for the purchase of goods and services . Examples of credit money include personal I.O.U.’s, and in general any financial instrument (such as a treasury bond, savings bond, corporate bond or bank money market account certificate) which is not immediately repayable (redeemable) on demand. In certain cases, banknotes which are not legal tender may be seen as credit money, inasmuch as they are simply promisory notes issued by the bank (for example, see Pound Scots).
In terms of the money supply, credit money is generally associated with that part of M2 which is not M0.
During the Crusades in Europe, precious goods would be entrusted to the Roman Catholic Church’s Knights Templar, who effectively created a system of modern credit accounts. Over time this system grew into the credit money that we know today, where banks create money by approving loans - although the risk and reserve policies of each national central bank set a limit on this.
Sometimes, as in the United States during the Great Depression, trust in bank policies drops very low, and there is the risk of a bank run without government or other intervention. In the United States, the Federal Deposit Insurance Corporation was created in 1933 to prevent bank insolvency from affecting depositors.
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What is Risk?
Risk is the potential future harm that may arise from some present action. It is often combined or confused with the probability of an event which is seen as undesirable. Usually the probability and some assessment of expected harms must be combined into a believable scenario combining risk, regret and reward probabilities into expected value. There are many informal methods which are used to assess (or to “measure” although it is not usually possible to directly measure) risk, and (for some applications) formal methods such as value at risk.
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What is Usury?
Usury (from the Latin usus meaning “used”) was defined originally as charging a fee for the use of money. This usually meant interest on loans, although charging a fee for changing money (as at a bureau de change) is included in the original meaning. After moderate-interest loans became an accepted part of the business world in the early modern age, the word has come to refer to the charging of unreasonable or relatively high rates of interest.
Usury laws are state laws that specify the maximum legal interest rate at which loans can be made. This makes most loansharking, another name for usury, illegal. Often, loansharks use illegal “scare” tactics to ensure that the lent money is paid back.
Usury (in the original sense of any interest) is scriptually and doctrinally forbidden in many religions. Judaism forbids a Jew to lend at interest to another Jew. It’s forbidden in Islam. The most recent Catholic teaching on usury is by Pope Benedict XIV in his Vix Pervenit from 1745 which strictly forbids the practice, though many Jews, Catholics and Muslims break their own laws in this matter.
While Jewish law forbids the charging of interest to another Jew, Jews are not forbidden to charge interest on transactions to non-Jews. Throughout history, the interest attached to loans by Jews to non-Jews is widely considered to have been a central issue in causing a perception of usury, and contributing to a climate of anti-Semitism: Forceful confiscations of property, and discrimination toward Jews in business practice. Ethnic-based distinctions surrounding the application of interest charges are often perceived as pronounced, discriminatory and unjust, and can inflame existing ethnic divisions.
Usury has been denounced by almost every major spiritual leader and philosopher of the past three thousand years. Plato, Aristotle, Cato, Cicero, Seneca, Plutarch, Aquinas, Jesus, Mohammed and Moses are just a few.
Cato in his De Re Rustica said:
“And what do you think of usury?”
“What do you think of murder?”
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What is Interest Rate?
An interest rate is the “rental” price of money. When a resource or asset is borrowed, the borrower pays interest to the lender for the use of it. The interest rate is the price paid for the use of money for a period of time. One type of interest rate is the yield on a bond.
When money is loaned the lender defers consumption (or other use of the money) for a specific period of time. The lender does this in exchange for an expected increase in future income. The expected increase in real income (relative to the amount loaned) is the real interest rate. Note that the real interest rate is calculated by adjusting the actual rate charged (known as the money or nominal interest rate) to take inflation into account. (See real vs. nominal in economics.) A first approximation for the real interest rate for a one-year loan is:
-
- ir = in — pe
where:
- in = nominal interest rate
- ir = real interest rate
- pe = expected or projected inflation over the year.
After the fact, there is the realized or ex post real interest rate:
-
- ir = in — p
where p = the actual inflation rate over the year.
Thus, if the (expected) inflation rate is 5% and the nominal interest rate is 7%, the (expected) real interest rate is 2%.
If financial markets have adjusted for the effects of expected inflation and the real interest rate is given, then the nominal rate approximately equals:
-
- ir + pe
Thus, if the real interest rate is 3% and the inflation rate equals 5%, the nominal interest rate = 8%. The theory of rational expectations is sometimes applied to say that this equation applies in most cases. Most economists would agree that it applies over several years, as financial markets adjust: higher inflation leads to higher nominal rates, all else being equal.
Irving Fisher proposed a better approximation of the relationship between nominal interest rate, inflation and real interest rate. For a one-year bond, the expected real rate equals
-
- ir = [(1 + in)/(1 + pe)] — 1
Using the first numerical example above, the expected real rate equals [1.07/1.05]-1 = 0.19 or 1.9%, which is similar to (but not the same as) the 2% calculated above.
When comparing different interest rates on different kinds of loans, a different kind of formula is used. For the nominal rate on a single type of asset,
- in = i*n + d + mrp + lp
- i*n = the nominal interest rate on a short-term risk-free liquid bond (such as U.S. Treasury Bills).
- d = default premium (reflecting the likelihood of default by the borrower)
- mrp = maturity risk premium (risk factor for length of borrowing period)
- lp = liquidity premium (reflecting the perceived difficulty of converting the asset into money and thus into goods).
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What is a Debenture?
In finance, a debenture is a long-term debt instrument used by governments and large companies to obtain funds. It is similar to a bond except the securitization conditions are different. A debenture is unsecured in the sense that there are no liens or pledges on specific assets. It is however, secured by all properties not otherwise pledged. In the case of bankruptcy debenture holders are considered general creditors.
The advantage of debentures to the issuer is they leave specific assets unencumbered, and thereby leave them open for subsequent financing.
In practice the distinction between bond and debenture is not always maintained. Bonds are sometimes called debentures and vice-versa.
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What is a Loan?
A loan is a type of debt. Like all debt instruments, a loan entails the redistribution of financial assets over time, between the lender and the borrower. The borrower initially receives an amount of money from the lender, which they pay back, usually but not always in regular instalments, to the lender. This service is generally provided at a cost, referred to as interest on the debt.
Acting as a provider of loans is one of the principal task for financial institutions. For banks loans are generally funded by deposits. For other institutions issuing of debt contracts, such as bonds is a typical source of funding.
Other types of debt include mortgages, credit card debt, bonds, and lines of credit. A mortgage is a very common type of debt instrument, used by many individuals to purchase housing. In this arrangement, the money is used to purchase the property. The bank, however, is given the title to the house until the mortgage is paid off in full. If the borrower defaults on the loan, the bank can reposess the house and sell it, to get their money back.
The abuse in the granting of loans is known as predatory lending. It usually involves granting a loan in order to put the borrower in a position that one can gain advantage over them.
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What is Currency?
A currency is a unit of money (or monetary unit). Typically, each country has given monopoly to a single currency, controlled by a state owned central bank, although exceptions from this rule exist. Several countries can use the same name, each for their own currency (e.g. Canadian dollars and US dollars), several countries can use the same currency (e.g. the Euro), or a country can declare the currency of another country to be legal tender.
Each currency typically has one fraction currency, valued at 1/100 of the main currency: 100 cents = 1 dollar, 100 centimes = 1 franc. However, some currencies use a fraction of 1/10 (and a very few some other value such as 1/5 or 1/20), or do not have a minor unit currency at all. These fractions are NOT listed below.