Thursday, March 22, 2007

More geeky musings

winterspeak reader DL responds to my recent post on interest rates vs. time preference discount rates:
A future consumption good is always discounted to a present value by a rate of time preference independent of whether borrowed money is involved or not.While the discount rate involved is not identical to market interest rates, they cannot be truly independent of one another.
This is exactly right, and leads to the question: what is the relationship between the discount rate and market interest rate? It is true they cannot be truly independent, as to a certain degree your willingness to wait for something depends on how much you are compensated for waiting. On the other hand, they clearly are not the same thing either -- market interest rates bounce all over the place, whereas people's patience to wait for something is more constant.

It is also true that behavioral finance shows that people have inconsistent time preferences -- delaying between right now and later is a bigger deal than delaying between later and even later.

What happens when the interest rate is below the time preference discount rate (so the bank pays 1%, but you are discount at 5%). Do you move consumption forward? Alternatively, if the positions are reversed (the bank pays 10%, you still discount at 5%) do you delay consumption? And how much can you really shift consumption forward?

It's easy to delay consumption -- you just save and buy what you were going to buy anyway, later. But to move consumption forward it harder -- you cannot eat dinner twice today and not need to eat it tomorrow. Eating dinner twice today is increasing consumption, but not moving it forward. Apart from buying durable goods earlier, I'm not sure what else you can do.

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