What the Heck are Interest Rates?

Have you ever wondered how interest rates work? What they are? Perfect, so have I for the longest time. I read a lot of literature and books to try and figure out exactly what interest rates are. I was surprised to see how simple the explanation for this concept was once I delved into the Austrian Economic literature on the subject. I think that mainstream economics purposefully confuses the topic. They want you to think that the Federal Reserve can in fact manipulate interest rates and they want you to be so confused by the subject that you leave the policy making up to them as “experts”. Perpetuating the idea that economics is “the dismal science” keeps economic policy making and “understanding” in their hands while they bamboozle everyone.

First let us define what interest rates are. Interest rates are the value of present goods against future ones. That is it! I could end this article here but I know that that would probably make a few people upset if I did not go into further detail. The fascinating thing about interest rates is that they have been around as long as civilization has. The ancient Mesopotamian people had clay receipts and tablets that dictated the rate of interest on a loan. Borrowers had to pay interest and the original interest rates very well could have been based on the natural increases that would occur in the heard of livestock.

As a rule, individuals generally prefer the consumption of present goods over future ones. As temporal beings in a finite reality, we lack patience. If the choice is between a $1000 right now or a $1000 dollars in the future, the choice is generally for $1000 dollars at this moment. But, due to subjective valuations (varying preferences from individual to individual), trades through time can occur. Let us look at two economic actor’s value scales to understand this:

Person A:

  1. $2,000 dollars in one year
  2. $1,500 dollars right now
  3. $1,250 dollars in a year
  4. $1,500 dollars in a year

Person B:

  1. $2,500 dollars in one year
  2. $1,500 dollars right now
  3. $1,700 dollars in one year
  4. $1,500 dollars in one year

Person A’s premium on the present is $500 dollars. To calculate the rate of interest they prefer, just divide 500 by 1,500. This gives us a rate of interest of 0.33. Person B’s premium on the present is $1000 dollars. By using the same basic mathematics, we can see that their pure rate of interest is 0.66. Person B has a high time preference so in this scenario, person be is the borrower while person A is the lender. This means that, after negotiations between the two occur, the rate of interest will be some where between 0.33 and 0.66. From this we can conclude that people with higher time preferences demand money now. This is what makes the borrowers. Lower time preference people are ok with money later. This is what makes them lenders.

If you want to learn more about this, use Tom Woods Liberty Classroom and take the “Austrian Economics Step by Step” course taught by Jeff Herbener.

Once this was explained to me, the confusion of interest rates disappeared. From the above construction, we can see how the attempts of central banks to artificially manipulate interest rates muddies the water. Mises wrote in Human Action “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.” Interest rates can never truly be set by central banks because it is the individual economic actors that set interest rates on the unhampered market. Mises remarks are easily logically deduced. A person who barely has enough to survive will probably not engage in lending or spending even if he was offered very high interest rates to do so. But as he labors and expands his wealth, the cost of investing and lending decreases for him making it more likely that his time preference lowers, and by extension the likely hood that he will lend, more likely.

So what happens when the money supply artificially and aggressively increases? It means that those that have received the new money are now wealthier. As we have just demonstrated, their new wealth means the cost of lending decreases and the incentive to lend and invest increases. This increase in lending means a lowering of the demand for money among the investor and lenders. A lowering in the demand for money increases due to this monetary surplus, prices rise. As this continues to occur, the time preference of individuals begins to change. This desire for money now puts pressure on interest rates. This leads to a disparity or distortion and leads to the famous Austrian Boom/Bust cycle. The central banks are not going to let interest rates adjust to market demands and this alteration of course causes major problems in the economy. This is my it isn’t completely true that central banks set interest rates. They attempt to, but generally it ends up hurting everyone. It is simply the price of trying to control the uncontrollable.

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  1. Pingback: Logical Anarchy Today Episode 94 – Obama Meets Yellen in Secret After Closed Off Fed Board Meeting | Logical Anarchy

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