The essence of interest rate determination

According to mainstream thinking the Central Bank is the key factor in determining interest rates. By setting short-term interest rates the Central Bank, it is argued through expectations about the future course of its interest rate policy influences the entire interest rate structure. (According to the expectations theory (ET) the long-term rate is an average of the current and expected short-term interest rates). Note that interest rates in this way of thinking is set by the Central Bank whilst individuals in all this have almost nothing to do and just form mechanically expectations about the future policy of the Central Bank. (Individuals here are passively responding to the possible policy of the Central Bank).

Following the writings of Carl Menger and Ludwig von Mises we suggest that the driving force of interest rate determination is individual’s time preferences and not the Central Bank.

As a rule people assign a higher valuation to present goods versus future goods. This means that present goods are valued at a premium to future goods.

This stems from the fact that a lender or an investor gives up some benefits at present. Hence the essence of the phenomenon of interest is the cost that a lender or an investor endures. On this Mises wrote,

That which is abandoned is called the price paid for the attainment of the end sought. The value of the price paid is called cost. Costs are equal to the value attached to the satisfaction which one must forego in order to attain the end aimed at.[1]

For instance, an individual who has just enough resources to keep him alive is unlikely to lend or invest his paltry means. The cost of lending, or investing, to him is likely to be very high – it might even cost him his life if he were to consider lending part of his means. So under this condition he is unlikely to lend, or invest even if offered a very high interest rate.

Once his wealth starts to expand the cost of lending, or investing, starts to diminish. Allocating some of his wealth towards lending or investment is going to undermine to a lesser extent our individual’s life and well being at present. From this we can infer, all other things being equal, that anything that leads to an expansion in the real wealth of individuals gives rise to a decline in the interest rate i.e. the lowering of the premium of present goods versus future goods. Conversely factors that undermine real wealth expansion lead to a higher rate of interest rate.

Time preference and supply demand for money

In the money economy individuals’ time preferences are realized through the supply and the demand for money. The lowering of time preferences, i.e. lowering the premium of present goods versus future goods, on account of real wealth expansion, will become manifest in a greater eagerness to lend and invest money and thus lowering of the demand for money.

This means that for a given stock of money there will be now a monetary surplus.

To get rid of this monetary surplus people start buying various assets and in the process raise asset prices and lower their yields, all other things being equal. Hence, the increase in the pool of real wealth will be associated with a lowering in the interest rate structure.

The converse will take place with a fall in real wealth. People will be less eager to lend and invest thus raising their demand for money relative to the previous situation. This for a given money supply reduces monetary liquidity – a decline in monetary surplus. Consequently, all other things being equal this lowers the demand for assets and thus lowers their prices and raises their yields.

What will happen to interest rates as a result of an increase in money supply? An increase in the supply of money, all other things being equal, means that those individuals whose money stock has increased are now much wealthier.

Hence this sets in motion a greater willingness to invest and lend money. The increase in lending and investment means the lowering of the demand for money by the lender and by the investor. Consequently, an increase in the supply of money coupled with a fall in the demand for money leads to a monetary surplus, which in turn bids the prices of assets higher and lowers their yields.

As time goes by the rise in price inflation on account of the increase in money supply starts to undermine the well being of individuals and this leads to a general rise in time preferences. This lowers individuals’ tendency for investments and lending i.e. raises the demand for money and works to lower the monetary surplus – this puts an upward pressure on interest rates.

In a market economy within the framework of a central bank, the key factor that undermines the pace of real wealth expansion is the monetary policy of the central bank.

It is loose monetary policy that undermines the stock of real wealth and the purchasing power of money. We can thus conclude that a general increase in price inflation on account of an increase in money supply and a consequent fall in real wealth is a factor that sets in motion a general rise in interest rates whilst a general fall in price inflation in response to a fall in money supply and a rise in real wealth sets in motion a general fall in interest rates.

Furthermore, an increase in the growth momentum of money supply sets in motion a temporary fall in interest rates, whilst a fall in the growth momentum of money supply sets in motion a temporary increase in interest rates.

[1] Ludwig von Mises, “Human Action” Contemporary Books, 3rd revised edition p 97.