The Nature of Discounting
23 Pages Posted: 7 Aug 2009 Last revised: 11 Mar 2010
Date Written: August 4, 2009
Abstract
From monetary policies to climate change problem, from the burden of private credit card debts to the evaluation of public projects, discount rate is the central issue. Yet, there is little clear understanding about the nature of discounting. The main problem in the theory of discounting is that “an economist who knows the literature well” is “able to justify any reasonable social discount rate by some internally consistent story”. In this paper, applying a newly developed production theory, we discuss how discount rate is related to other factors in biological and social production systems, such as risk, duration of project or life span, fixed cost of project and size of market. The relations among different factors in a production system will put constraints on the range of discount rate that is viable in particular environments. Our findings have strong policy implications. When the cost of extracting nonrenewable resources is low, lower interest rate policy will help accelerate economy growth. With steady increase of the cost of extracting natural resources, steady economic growth has become increasingly difficult. In such environment, a gradual increase of interest rate will provide a gentle soft landing instead of wide gyration of social systems that we have witnessed in the recent years under the mainly low interest rate environment.
Keywords: Discounting, risk, duration of project, fixed cost, natural resources, monetary policy, climate change
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