Unit 9 Lenders and borrowers and differences in wealth

9.14 Summary

  • The income a person receives in a period of time may be consumed, or saved in the form of financial or physical assets, adding to their stock of wealth.
  • Borrowing or selling assets allows consumption spending to exceed income; this reduces the stock of wealth.
  • Timing matters; a person cares not only about what they get, but also when they get it. Sooner is typically better than later, which is termed impatience.
  • A person can rearrange the timing of their spending by borrowing, lending, investing, storing, and saving; and those with more wealth typically have more and better opportunities to do this than poorer people.
  • Borrowing and lending is a principal–agent relationship in which there is no contract that can guarantee for the lender (the principal) that the loan will be repaid by the borrower (the agent).
  • To address this problem, lenders often require borrowers to either contribute some of their own wealth to an investment project (equity) or to set aside a property to be transferred to the lender if the loan is not repaid (collateral).
  • People with limited wealth are unable to contribute collateral or equity and, as a result, are often unable to secure loans (except for purchasing homes or vehicles) or can only do so at higher interest rates.
  • While mutual gains for both borrowers and lenders motivate credit market transactions, there is a conflict of interest between them over the rate of interest, the prudent use of loaned funds, and the repayment of loans.
  • Investments are risky, and should things go wrong, those with limited wealth are not able to borrow on as favourable terms as the wealthy; so they avoid taking risks and as a result forgo opportunities to raise their incomes, which perpetuates wealth inequality.

Concepts and models introduced and applied in Unit 9