A person with money has the ability to buy products or services right the second he wants to. If someone wants to make purchases but does not currently have the money, she can rent purchasing power by borrowing. Similar to this, if someone else has money now but wants to put off making purchases, he can rent out his purchasing power. Keep in mind the importance of the interest rate in this situation. It stands to reason that the propensity to put off purchases into the future depends on the incentive, or interest rate. In general, the larger the incentive and, consequently, the greater the willingness to defer purchases into the future and lend in the present, the higher the interest rate, ceteris paribus.
The borrowing side follows the same logic. If someone wants to buy products or services but lacks the means to do so, they have two options: borrow now and buy now, or save now and buy later. We can conclude that, ceteris paribus, the higher the interest rate, the less appealing option appears and the more attractive option gets since, among other things, the willingness to borrow relies on the cost.
The significance that the interest rate plays in connecting the present and the future is the main takeaway from this debate. Spending the amount lent plus interest in the future is made possible by lending money today. Spending today is made possible by borrowing money today, but you must pay it back plus interest later.
The interest rate plays a crucial part in decisions made regarding spending, saving, borrowing, and lending in the present and with implications for the future because it is the return on loan and the cost of borrowing. The temporal worth of money is the name of the idea. Simply said, because it specifies the conditions under which a person might exchange present purchasing power for future purchasing power, the interest rate serves as a representation of the time value of money.
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