Would it be possible in a world without money to establish the rate of return on present goods in terms of future goods? In a world without money all that one would have are the rates of exchanges between various present and future real goods. For instance, one present apple is exchanged for two potatoes in one-year’s time. Or, one shirt is exchanged for three tomatoes in a one-year’s time. All that we have here are various ratios.
There is, however, no way to establish from these ratios what the rate of return is for one present apple in terms of future potatoes (It is not possible to calculate the percentage since potatoes and apples are not the same goods). Likewise we cannot establish the rate of return on a shirt in terms of future tomatoes. In other words, we can only establish that one present apple is exchanged for two future potatoes, and one present shirt is exchanged for three future tomatoes. Only in the framework of the existence of money can the rate of return be established.
For instance, the time preference of a baker, which is established in accordance with his particular set-up, determines that he will be ready to lend ten dollars – which he has earned by selling ten loaves of bread – for a borrowers promise to repay eleven dollars in a one year’s time.
Similarly the time preference of a shoemaker, which is formed in accordance with his particular set-up, determines that he will be a willing borrower. In short, once the deal is accomplished both parties to this deal have benefited. The baker will get eleven dollars in one-year’s time that he values much more than his present ten dollars. For the shoemaker the value of the present ten dollars exceeds the value of eleven dollars in one-year time.
As one can see here, both money and the real factor (time preferences) are involved in establishing the market interest rate, which is 10%. Note that the baker has exchanged ten loaves of bread for money first, i.e. ten dollars. He then lends the ten-dollars for eleven dollars in one-year’s time. The interest rate that he secures for himself is 10%. In one-year’s time the baker can decide what goods to purchase with the obtained eleven dollars. As far as the shoemaker is concerned he must generate enough shoes in order to enable him to secure at least eleven dollars to repay the loan to the baker.
Observe however, that without the existence of money – the medium of exchange – the baker isn’t able to establish how much of future goods he must be paid for his ten loaves of bread that would comply with the rate of return of 10%.
Consequently, there cannot be any separation between real and financial market interest rates. There is only one interest rate, which is set by the interaction between individuals’ time preferences and the supply and demand for money.
Since the influences of demand and supply for money and individuals’ time preferences regarding interest rate formation are intertwined, there are no ways or means to isolate these influences. Hence, the commonly accepted practice of calculating the so-called real interest rate by subtracting percentage changes in the consumer price index from the market interest rate is erroneous.