Interest Rates And Gremlins

Everyone is familiar with the term “interest rate”, but most people don’t understand what the term means. Unless you understand what the term means, you won’t fully understand why the central bank’s ‘management’ of interest rates damages the economy.

To understand what the interest rate is, it helps to understand what it isn’t. It isn’t the price of money. The price of money is what money buys, which can be different in every transaction. For example, if an apple is priced at $1, a new car is priced at $30,000 and a dental checkup is priced at $100, then the price of a dollar can be said to be 1 apple or 1/30000th of a car or 1/100th of a dental checkup.

The interest rate is the price paid by a borrower for a temporary increase in his purchasing power, or, looking at it from a different angle, the price received by a lender in consideration for temporarily giving up some of his purchasing power. This price will naturally take into account the risk that the borrower will be unable to make full repayment (credit risk) and the risk that money will be worth less in the future than it is at the time the loan is made (inflation risk). However, even if there were no credit or inflation risk to consider the interest rate would still be positive. The reason is that a unit of money in the hand today will always be worth more than a promise to pay a unit of the same money in the future.

This means that as well as being determined by the risk of default and the risk of inflation, the interest rate in any transaction will be determined by the time preferences of the borrower and lender. Someone with a strong desire to consume in the present has a high time preference. It’s likely that if this person has insufficient money to satisfy his immediate desire to consume then he will be willing to pay a high rate of interest to temporarily increase his purchasing power. Alternatively, it’s likely that someone whose desire to consume in the present is low relative to the amount of cash he has on hand will be willing to lend money to the right borrower at a relatively low rate of interest.