Hey everybody, welcome back to explain that come fire. The podcast where we take the questions you always wanted to ask and talk about them in a way that's easy to understand. We are your hosts, I'm Tim. And I'm Kevin.
So Kevin, today we're talking about something that's been in the news a lot and that is interest rates. How does raising interest rates slow or lower inflation? Ah, yes, interest rates are really important to our modern economy. So people, right?
They like to borrow money to pay for things. And when interest rates rise, basically the cost of borrowing that money also goes up. And since borrowing now costs more, people have a little bit less money to spend. And then since people spend less money, therefore the price of goods and services don't go up as quickly, hence inflation is lowered.
So you can kind of think of interest rates as the quote unquote price of money. It tells you how much money you have to earn in the future to get a certain amount of money now. And so the opposite to what I just said would be more like what's happening today. When interest rates are low, people are going to be like, oh, that's really cool.
I can get stuff now and work to kind of buy it later. So they buy more stuff and when you buy more stuff, you usually tend to get higher inflation. So if inflation keeps up at something like 7% per year and my student loan interest is 5% does that mean that effectively I'm getting a 2% in loan forgiveness each year? Yes, actually, you have basically correctly applied the Fisher equation, which describes exactly what you said, the relationship between nominal interest rates and the real interest rates under inflation.
So real interest rates here are interest rates taking account the inflation rate. So why do banks lend at an interest rate lower than inflation sometimes? If they do that, don't they lose money? Well, how banks work is that they make money off of the spread between the deposit and the loan rates.
Inflation, it doesn't even factor directly into that. The bank, they don't really use money of its own. It controls other people's money, right? So when I say the bank loses money in real terms, it really means the depositors, like you and me, if we've got money saved in a bank, we are the ones losing money in real terms.
So let's say, for example, I have a CD, a certificate deposit at a 1% interest. Now the bank can lend any money I put into that CD for 2%, effectively collecting that 1% spread between the difference, right? Now the bank, they don't care what inflation is at all. And also if a bank sits on cash for a year and inflation is 5%, they do lose 5% in real terms.
They lend the money out at 2%. They only lose 3% in real terms. So I think one other final important thing to consider is that banks usually issue loans of like 10 years or more. So while momentary inflation matters some, it's the long-term inflation expectations that matter more when you're talking about the total loan profitability.
So this concept of interest and interest rates, it's been around for some time now, right? How long does it go back in history? Yeah, yeah. The first attempt to control interest rates through the manipulation of the money supply was actually made by the Bank of France in 1847.
So pretty recent. But I think when you're talking about the lending of food money, it was commonplace in Middle Eastern civilizations as early as 5,000 BC. An argument that acquired seeds and animals could reproduce themselves was used actually to justify interest. But there was also Jewish religious prohibitions against what we call usury.
So what is usury? Usury here is the practice of making unethical or immoral monetary loans that unfairly enriched a lender. So usury in the original sense of interest was actually really denounced by religious leaders and philosophers in the ancient world. And everyone from Moses, Plato, Aristotle, Cicero, Buddha, and Mohammed.
That's right. So there's no interest in Islamic finance or Sharia-compliant finance, right? Yes. So some countries like Iran, Sudan, and Pakistan, they have taken steps to eradicate interest from their financial systems.
They practice something called Islamic banking or Sharia-compliant finance, which is banking our financial activity that complies with Sharia Islamic law. And it's practical application through the development of Islamic economies. How does it work then? So it's very interesting.
Rather than charging interest, the interest-free lender shares the risk by investing as a partner in the profit-loss sharing scheme because predetermined low repayment as interest is prohibited. And making money out of money is also unacceptable. So all the financial transactions must be acid-backed. And it does not charge any interest or fee for that service of lending.
So a final question that comes up with interest rates, and that is the difference between countries and different currency interest rates. Why do people not borrow money from low interest rate countries like Japan and then deposit in that money into higher interest rate countries like Argentina? Oh, well, the actual rate you're describing has actually happened in the past. And it's likely actually happening today as well.
In finance parlance, it even has a name. It's called a carry trade. And the best known carry trade was actually in the 90s, basically borrowing the Japanese yen and then buying the US dollar. It's kind of usually these really big institutions who execute it though, since it's pretty difficult for individual investors to do.
So does it work? It definitely can, but not all the time. It's all about the relationship between inflation, interest rates, and now currencies. So you could borrow at something like 2% of Japan, invest at 12% Argentina, resulting in that nominal interest rate of 10%.
But then if you look at inflation, if inflation is 0% in Japan but then 10% Argentina, then your gains are going to be wiped out because of that decreasing value of the Argentine peso as compared to the Japanese yen. So after adjusting for the inflation component, that previous 10% nominal value becomes a pretty much a 0% real interest rate. Interesting that our inflation episode from a few months back actually is one of our most popular episodes. If you want to dig into that other component inflation, do go and take a listen to that.
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