Interest is the direct outcome of individual time preference. In a credit transaction, a present good is traded in exchange for the same good in future. The person who surrenders the present good will be asking for more units of the future good, according to his time preference. The person asking for the present good will evaluate whether the future goods he surrenders are lower on his time preference scale than the present goods he receives.

If individual A is willing to immediately surrender 1000 money units against at least 1200 units in 2 years, and B is willing to accept 1000 present money units against a maximum of 1500 in 2 years, both parties will accept an exchange where A surrenders 1000 units and B in exchange surrenders anything between 1200 and 1500 units.

A will accept 1200 or more units in 2 years against surrendering 1000 immediately. However, it is important to mention that a credit transaction involves a risk that the initial amount and the premium will never be repaid. Another person C might be willing to accept 1000 of present money units against a maximum of 1200 in 2 years, but be more trustworthy and less risky from A’s point of view. A has hence the alternative to enter into a less risky transaction with C against 1200 units in 2 years or to approach B and ask for more money units in two years. A could, for example, agree with B to exchange the 1000 present money units against 1300 money units in 2 years.

If 1000 present money units are traded against 1300 units in 2 years, the interest paid in this transaction is 300 units. It is customary to express interest in the form of an interest rate, which is the percentage of the interest money paid per year against the immediate money surrendered. This example would be a 15% (150 units per each year divided by 1000 units ) annual interest rate for a 2 year credit transaction. It is immaterial to the concept of interest rates how exactly the transaction is structured. Interest payments and repayment of the amount surrendered could be made on a monthly basis, on an annual basis, settled after 2 years, or in any other conceivable manner.

An interest rate is comprised of two components. In our example, the first component is the one that satisfies A’s time preference demands ( 200 money units over 2 years or 10% per year). The second component is a risk premium that he realizes due to his B’s willingness to pay up to 1500 money units (100 additional money units over 2 years or 5% per year). We shall call the former component the Time Interest Component, the latter the Entrepreneurial Interest Component.

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