Popular Interest Rate Theory Describes but Fails to Explain

According to much popular economic thinking, there are three factors determining the market interest rates. The first is liquidity, the second factor is economic activity, and the third factor is inflationary expectations. Milton Friedman held that whenever the central bank raises the growth rate in money supply by buying financial assets such as Treasuries this pushes the prices of Treasuries higher and its yields lower. Note that what we have here is the monetary liquidity effect, which is inversely correlated with interest rates.

After a time lag, maintains Friedman, the increase in the money supply strengthens economic activity and this sets in motion the economic activity effect, which is exerting an upward pressure on the interest rates. After a much longer time lag, the increase in the growth rate of money supply begins to affect the prices of goods and services. Once prices start to move higher, inflation expectations are emerging. Consequently, this exerts a further upward pressure on the market interest rates.

Liquidity, economic activity, and inflation expectations are seen as the key factors in the determination of the interest rates. This process is set by the central bank’s monetary policies, which influences the monetary liquidity. The monetary liquidity in turn gives rise to the other two effects.

That said, this popular explanation of interest rate determination is derived from observations and not from a sound economic framework that interprets observations. In The Ultimate Foundation of Economic Science, Mises argued that,

What economic history, observation, or experience can tell us is facts like these: Over a definite period of the past the miner John in the coal mines of the X company in the village of Y earned p dollars for a working day of n hours. There is no way that would lead from the assemblage of such and similar data to any theory concerning the factors determining the height of wage rates.

Thus, such a theory of interest rate determination does not explain, it only describes. 

Time Preference and Interest Rates

Human nature requires some level of present consumption. We know that to stay alive an individual must consume goods in the present. Since all human action necessarily takes place in time present goods command a higher premium than identical future goods.

Consider a case where an individual has just enough goods to keep himself alive. This individual is unlikely to lend or invest his paltry means. The cost of lending, or investing, to him is very high—it might even cost him his life if he were to consider lending or investing part of his means. Once his wealth starts to expand, the cost of lending or investing starts to diminish. 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.

According to Carl Menger:

To the extent that the maintenance of our lives depends on the satisfaction of our needs, guaranteeing the satisfaction of earlier needs must necessarily precede attention to later ones. And even where not our lives but merely our continuing well-being (above all our health) is dependent on command of a quantity of goods, the attainment of well-being in a nearer period is, as a rule, a prerequisite of wellbeing in a later period…. All experience teaches that a present enjoyment or one in the near future usually appears more important to men than one of equal intensity at a more remote time in the future.

Again, once an individual’s savings starts to expand, the cost of lending or investing begins to diminish. Allocating some of his resources towards lending and investment becomes feasible. From this we can infer, all other things being equal, that anything that leads to the expansion or private production and saving will result in the reduction of the premium of present goods versus future goods (i.e., a decline in the interest rate). Conversely, factors that undermine the expansion of private production and saving will increase the premium of present goods versus future goods (i.e., an increase in the interest rate).

Individuals’ responses to changes in available resources and savings in terms of the time preferences are not automatic. Every individual decides how much will be allocated to present consumption versus future consumption based on his ends.

Time preference theory does not conceptually require the existence of money in order to ascertain the interest phenomena. Also, within Friedman’s framework, changes in economic activity are positively associated with the interest rates. However, if the increase in economic activity is on account of the expansion of private production and saving this is likely to produce a decline in time preferences, and thus, to the lowering of the interest rates, not increases as suggested.

Interest Rates and the Increase in Money Supply

When money and credit are inflated and injected into the economy, this sets in motion an exchange of nothing for something. The earlier receivers of the inflated money and credit can now divert resources to themselves. Similar to a counterfeiter, by diverting resources to themselves, the receivers of the new money and credit have now become wealthier than before. This means that they can now increase the purchases of various goods, thus pushing their prices higher and their yields lower. As long as private production and savings are expanding, all other things being equal, individuals’ time preferences are likely to decline. Conversely, with less saving, time preferences will increase and the market interest rates are expected to increase.

In a free market, interest rates will correspond to individuals’ time preferences. Whenever, individuals’ lower their time preferences, this means that they are signaling businesses to arrange a suitable infrastructure in order to be ready for the increase in the demand for consumer goods in the future. Hence, if businessmen want to succeed, they must abide by consumer demand. In this sense, market interest rates are indicators. The policies of the central bank, however, distort interest rates. This distorts the economic calculation of entrepreneurs.

Individuals and Economic Causes

The fact that individuals consciously pursue purposeful actions implies that causes in the world of economics emanate from individuals and not simply from outside factors. Again, individuals’ responses to various outside factors are not automatic. Every individual assesses changes in various factors against his various ends. Hence, neither monetary liquidity, nor economic activity, nor inflation expectations are the essence of interest rate determination. Individual decisions regarding present consumption versus future consumption is the key determinant of interest rates.

Conclusion

By popular thinking, the market interest rate is determined by changes in monetary liquidity, economic activity, and inflationary expectations. In this way of thinking, an increase in the monetary liquidity pushes the interest rates lower. Increases in economic activity and increases in inflationary expectations drive interest rates higher. This framework depicts individuals as unconscious entities that react mechanistically to various factors. However, individuals’ conscious and purposeful action regarding present consumption versus future consumption is the key determinant of the interest rates.