Posted by John on .
Let's consider a three-month U.S. government bond. The interest rate on these loans is very low because it includes only two of the five components. Which two components of the interest rate are most important for a three-month T-bond??
-Positive rate of time preference
-Expected inflation rate
-Transaction costs of screening and monitoring borrowers
-Risk that the borrower will default
- General uncertainty about the future
Hummm. First off, the borrower is the U.S. Government. So the transaction costs of screening seems right out. Second 3 months seems too short a time for me to worry about balancing my current vs future consumption or worry about economic conditions 3 months hence. So, strike 1 and 5. This leaves 2) expected inflation rate, and 4) risk the borrower will default. I would go with these two.