Dear Money: What it is, How it Works, Real Interest Rate

What Is Dear Money?

Dear money refers to money that is hard to obtain (e.g. by borrowing) because of abnormally high-interest rates. This is because people prefer to save when interest rates are high, and spend or borrow when rates are low. Put differently, the cost of money becomes more expensive.

Dear money is often referred to as tight money because it occurs in periods when central banks are tightening monetary policy. It may be contrasted with loose or "cheap" money.

Understanding Dear Money

Dear money can be a result of a restricted money supply, causing interest rates to be pushed up due to the forces of supply and demand. In such a case, people prefer to hold on to their cash instead of lending it out or investing it in new projects, which indicates a shift in liquidity preferences away from lending. As a result, borrowers may have a hard time obtaining cash.

Businesses may have a tough time raising capital during a period of dear money, which severely dampens growth as it becomes too expensive to invest in technology and other capital expansions. Likewise, borrowing in the bond market becomes more expensive, which also can put a damper on growth prospects.

Cheap money, on the other hand, is money that can be borrowed with a very low-interest rate or price for borrowing. Cheap money is good for borrowers, but bad for investors, who will see the same low-interest rates on investments like savings accounts, money market funds, CDs, and bonds. Cheap money can potentially have detrimental economic consequences as borrowers take on excessive leverage if the borrower is eventually unable to pay all of the loans back.

Tight Monetary Policy

Tight, or contractionary monetary policy is a course of action undertaken by a central bank such as the Federal Reserve to slow down overheated economic growth, to constrict spending in an economy that is seen to be accelerating too quickly, or to curb inflation when it is rising too fast.

The central bank tightens policy or makes money tight by raising short-term interest rates through policy changes to the discount rate, also known as the federal funds rate. Boosting interest rates increases the cost of borrowing and effectively reduces its attractiveness. Tight monetary policy can also be implemented via selling assets on the central bank's balance sheet to the market through open market operations (OMO).

Dear Money and the Real Interest Rate

The real interest rate of an investment is calculated as the difference between the nominal interest rate and the inflation rate:

Real Interest Rate = Nominal Interest Rate - Inflation 

For example, if interest rates are 12 percent, and inflation is 3 percent, the real interest rate is 9 percent, meaning firms need to generate real growth of 9 percent to make it worthwhile.