Discount rate: Difference between revisions

Revision as of 09:45, 25 August 2008

Main Article

Discussion

Discount rates in cost/benefit analysis

The social opportunity cost rate

The social opportunity rate is based upon the discount rates used for investment appraisal by private sector companies.

The social time preference rate

The social time preference concept of discounting, arises from the behavioural observation that people prefer immediate satisfaction to deferred satisfaction. Thus the term “discount rate” refers to the compensation in terms of increased utility that a person requires as inducement to defer consumption (usually as a percentage per annum). The discount rate that a person experiences assuming no expectation of changing circumstances, is sometimes termed his “pure time preference rate” - to distinguish it from the inducement that he would require if he expected his consumption to increase. In that case, he would take account of the fact that, as his total consumption increased, he would experience a reduction in the marginal utility of any further increase ^[1]. The proportionate further compensation that a person requires to take account of its diminishing marginal utility is referred to as that person’s “elasticity of the marginal utility of consumption”. (The derivation of that concept is attributed to a 1928 paper by the economist Frank Ramsey ^[2]. There is a note on the “Ramsey equation”, and the estimation of the associated elasticity measure, on the tutorials subpage.). A community’s discount rate, taking account of rising consumption, is termed its “social time preference rate”. The social discount rate of a community togeher with its liquidity prefernce are major determinants of its market interest rate.

Discount rates in financial theory

In financial theory, the uses of the term “discount rate” include its application to a variety of interest rates, including the rate charged for loans made to a country’s banks by its central bank ^[3], and the rates of return that are used as investment criteria by companies ^[4] and by government agencies ^[5].

References

↑ See the article on supply and demand
↑ Frank Ramsey “A Mathematical Theory of Saving” Economic Journal Vol. 38 1928
↑ See the article on financial economics
↑ See the article on business economics
↑ See the article on cost/benefit analysis

[1] See the article on supply and demand

[2] Frank Ramsey “A Mathematical Theory of Saving” Economic Journal Vol. 38 1928

[3] See the article on financial economics

[4] See the article on business economics

[5] See the article on cost/benefit analysis

[1]

[2]

[3]

[4]

[5]

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 {{subpages}}
-==Definition==
+==Discount rates in cost/benefit analysis==
-In economics, the concept of discounting, as used for the purpose  of [[cost/benefit analysis]], arises from the behavioural observation  that people prefer  immediate satisfaction to deferred satisfaction.  Thus the term “discount rate” refers to the  compensation in terms of increased utility that a person requires as inducement to defer  consumption  (usually as a percentage per annum).  The discount rate that a person  experiences assuming no expectation of changing circumstances,  is sometimes termed his  “pure time preference rate”  - to distinguish it from the inducement that he would require if he  expected his consumption  to increase.  In that case,  he would take account of  the fact that, as his  total consumption increased,  he would experience  a reduction in the marginal utility of  any further increase <ref>See the article on [[supply and demand]]</ref>.  The proportionate further compensation  that a person requires to take account of its diminishing marginal utility is referred to as that person’s  “elasticity of the marginal utility of consumption”.  (The derivation of that concept is attributed to a 1928 paper by the economist [[Frank Ramsey]] <ref> Frank Ramsey “A Mathematical Theory of Saving”  Economic Journal Vol. 38 1928</ref>.  There is a note on the “Ramsey equation”, and the estimation of the associated elasticity measure, on the tutorials subpage.).  A community’s discount rate, taking  account of rising consumption, is termed its “social time preference rate”. The social discount rate of a compunity togeher with its [[liquidity prefernce]] are major determinants of its market [[interest rate]].
+===The social opportunity cost rate===
+The social opportunity rate is based upon the discount rates used for investment appraisal by private sector companies.
-In financial theory, the uses of the term “discount rate” include its application to a variety of interest rates, including the rate charged for loans made to a country’s banks by its central  bank <ref> See the article on [[financial economics]]</ref>, and the rates of return that are used as investment criteria by companies <ref> See the article on [[business economics]]</ref>  and by government agencies <ref> See the article on [[cost/benefit analysis]]</ref>.
+===The social time preference rate===
+The social time preference  concept of discounting, arises from the behavioural observation  that people prefer  immediate satisfaction to deferred satisfaction.  Thus the term “discount rate” refers to the  compensation in terms of increased utility that a person requires as inducement to defer  consumption  (usually as a percentage per annum).  The discount rate that a person  experiences assuming no expectation of changing circumstances,  is sometimes termed his  “pure time preference rate”  - to distinguish it from the inducement that he would require if he  expected his consumption  to increase.  In that case,  he would take account of  the fact that, as his  total consumption increased,  he would experience  a reduction in the marginal utility of  any further increase <ref>See the article on [[supply and demand]]</ref>.  The proportionate further compensation  that a person requires to take account of its diminishing marginal utility is referred to as that person’s  “elasticity of the marginal utility of consumption”.  (The derivation of that concept is attributed to a 1928 paper by the economist [[Frank Ramsey]] <ref> Frank Ramsey “A Mathematical Theory of Saving”  Economic Journal Vol. 38 1928</ref>.  There is a note on the “Ramsey equation”, and the estimation of the associated elasticity measure, on the tutorials subpage.).  A community’s discount rate, taking  account of rising consumption, is termed its “social time preference rate”. The social discount rate of a community togeher with its [[liquidity prefernce]] are major determinants of its market [[interest rate]].
-==Economic Policy==
+==Discount rates in financial theory==
-One of the major issues in economics is what is an appropriate discount rate to use under various circumstances. For example, in assessing the impact of very long-term phenomena such as climate change, use of any discount rate much more than 1% per annum renders long-term damage (occurring in, say, 200 years time) of negligible importance now.
-Conversely, governments often take a short-term view of things, effectively applying discount rates of perhaps 20% p.a. or higher, on the grounds that anything they do or fail to do which has detrimental effects in (say) 10 or more years' time won't prevent their re-election sooner than that.
+In financial theory, the uses of the term “discount rate” include its application to a variety of interest rates, including the rate charged for loans made to a country’s banks by its central  bank <ref> See the article on [[financial economics]]</ref>, and the rates of return that are used as investment criteria by companies <ref> See the article on [[business economics]]</ref>  and by government agencies <ref> See the article on [[cost/benefit analysis]]</ref>.
-In practice, discount rates such as 2%, 3%, 5% and 10% are widely used in economics. However there is little consensus on what value is appropriate in any given circumstance, and it often makes a significant difference.
-==Context Specific Uses==
-;Credit cards : {{main|Merchant account}}
-:The discount rate is a percentage of the dollar amount of the transaction that a merchant is charged for each credit card transaction.
-;Monetary Policy : The discount rate is the rate that an eligible depository institution (such as a [[bank]]) is charged to borrow short term funds directly from the [[central bank]] through the [[Discount_window|discount window]]. This is also known as the '''base rate''', '''repo rate''' and/or '''primary rate''', as a profit-making bank will need to charge rates higher than this to its customers.
-==External links==
-*[http://www.richmondfed.org/publications/economic_research/instruments_of_the_money_market/ Instruments of the Money Market: Table of Contents]
-**[http://www.richmondfed.org/publications/economic_research/instruments_of_the_money_market/ch03.cfm Instruments of the Money Market: Chapter 3 - The discount window]
 ==References==
 <references/>