If you're seeing this message, it means we're having trouble loading external resources on our website.

If you're behind a web filter, please make sure that the domains ***.kastatic.org** and ***.kasandbox.org** are unblocked.

Main content

Current time:0:00Total duration:3:10

let's think about two different scenarios where I might borrow money from you so this is me over here and this is you in the first scenario I borrow money from you for a relatively short amount of time so I'm going to borrow I am going to borrow $100 from you $100 and then in one week in one week I will pay that $100 back to you I will pay back the hundred dollars and then I will play some interest some interest and will calculate the interest on an annual basis but obviously it'll be less than a year's interest because I'm paying for a week but we could annualize it it would give us some annual interest the other scenario is I borrow for a longer period of time so I'll do the other scenario in pink right over here so let's say I borrow $100 instead of paying you back in a week we agree that I can pay you back in two years in two years I'm going to pay you back $100 $100 plus plus some interest and what I want to think about here is there any reason why on an annual basis I should have a different interest rate for the short-term borrowing than the long-term borrowing you might say look it's the same guy this borrowing has the same credit rating has the same kind of legitimacy and all of that but you would say well look over here in a one week there's less of a chance of something catastrophic happening just there's there's more predictability here I you have a better sense of what the world one week from now is going to look like then you do two years maybe two years from now we enter into a hyperinflationary environment maybe I get hit by a truck maybe I lose a job there's a lot more that can happen in two years that could happen in one week and so you say look I think that this loan right here is riskier and it's not always the case that this would happen but many times you say look if I'm lending it for longer it's riskier there's more uncertainty so on an annual basis on an annual basis I would charge higher interest higher interest on an annual basis annual annual basis so maybe in this scenario up here you say look a week I'll charge you 5% per year interest so obviously the interest I would pay after a week would be some fraction of this some small fraction of five dollars of five percent and over here since there's more risk more uncertainty over two years I will charge you or you will charge me I should say 10 percent 10 percent per year and it's not always the case that the longer maturity debt is going to have higher interest although it tends to be the case if it goes lower we'll talk about in a future video it actually shows that something bad might be happening the economy or we might somehow be entering into a deflationary period but the whole point in this video is to show you that depending on how long someone borrows money from someone else they might want to charge a different amount of interest per year depending on maybe on unperceived risk the same thing is true when people lend to corporations or to the federal government we're going to see in the next video is how that plays out in the yield curve