What are interest rates?

Often politicians, economists and pundits talk about lowering interest rates to boost the economy by increasing lending. Right now, the Bank of England has interest rates at 0.5%, and the world over central banks have rates at record lows, all in the hope of stimulating the economy.

But before considering whether it’s appropriate for a central bank to set interest rates, we need to understand what interest rates are.

The simplest way to look at interest rates is that they represent the price of money. Therefore, the lower the interest rate, the cheaper it is for individuals and businesses to borrow money. This view of interest rates is easily seen if we look at an individual bank, without considering any central banks or other complications. When this bank has a large number of depositors saving money, the bank builds up it capital (or reserves) and can afford to charge a lower interest rate, as the supply of money is greater. As more money gets lent out, the interest rate of that bank will gradually have to rise as the supply dwindles. Across the economy as a whole, the interest rates will be set by the overall supply and demand for money. Therefore interest rates are prices, of a real good, money (or more accurately, capital). In this sense, interest rates are therefore not any different to the price of oil, or the cost of beef.

Seen in this light helps us to see that setting the price of money by fiat, through a central bank, won’t match the price to the actual supply and demand, which is likely to cause problems, as price controls always do. One of the key roles of prices is that of information – they are signals to the reality of underlying supply and demand.

Another very useful way to view interest rates, is  through the prism of time preference. All individuals place a different value on present versus future goods. Bob may decide to spend all his money now, on consumption, and not save anything. Bob would be said to have a “high time preference”. By contrast, Kate might decide to save a substantial partition of her income, in order to consume more in the future. Kate would have “low time preference”, at least in relation to Bob. Across the economy as a whole, the desire for future versus present consumption, determines the level of savings (and hence capital) available for loans. This then determines the natural interest rate. If the majority of individuals choose to save substantial parts of their income, then the interest rate would tend to be low, conversely, if most people are spending all of their money, the interest rate would be higher, as their is less funds available to be loaned out. In this way we see that the supply and demand of money is largely determined by individuals’ time preference.

From this angle, setting interest rates by government is to ignore the time preference of individuals. As prices are signals, or information, altering the natural rate of interest gives false information about the underlying reality. If the overall time preference is high (spend it all now!), then setting interest rates below the natural rate tells the market that time preference is lower than it really is.  This observation forms a key part of the Austrian Theory of the Business Cycle, where the false information contained within interest rates creates malinvestments. Entrepreneurs are fooled into thinking that the economy is made up of savers like Kate, and they plan to provide for future consumption, in longer production processes. This kicks off the boom. As the reality is that most people are like Bob, spending their money today, consumers have no money to spend when these long-term projects are ready, and these entrepreneurs are stuck with investments nobody can buy – a bust surely follows.

I’ll return to these themes in more detail in future posts.

As FA Hayek raps in the first of the awesome EconStories videos:

The boom gets started with an expansion of credit
The Fed sets rates low, are you starting to get it?
That new money is confused for real loanable funds
But it’s just inflation that’s driving the ones

Who invest in new projects like housing construction
The boom plants the seeds for its future destruction
The savings aren’t real, consumption’s up too
And the grasping for resources reveals there’s too few

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One Response to What are interest rates?

  1. Pingback: How supply and demand law determine the foreign exchange rate? | Foreign Exchange Market | Learn Forex, How Forex works, Learn to trade forex

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