July 19, 2016

Rarely does a month go by when I don’t read at least one article in which interest rates are said to be the price of money. This is wrong. The price of money is what money can buy. The rate of interest is something completely different.

If an apple sells for 1 dollar then the price of a unit of money in this example is 1 apple. If a car sells for 30,000 dollars then the price of a unit of money in this example is 1/30,000th of a car. In more general terms, just as the price of any good, service or asset can be quoted in terms of money, the price of money can be quoted in terms of the goods, services and assets that it buys. In a large economy, at any given time a unit of money will have millions of different prices.

As an aside, this is why price indices that purport to represent the purchasing power of money will always be bogus. Regardless of how rigorous and well-intentioned the effort, it is not possible to come up with a single number that properly indicates the “general price level”. There is simply no such thing as the general price level.

What, then, is the interest rate?

The interest rate is the cost incurred or the payment received for exchanging a present good for a future good. If there is no risk of loss involved in the transaction then the interest rate will reflect nothing other than the time preferences of the person who parts with the present good (usually called the lender) and the person who receives the present good (usually called the borrower). In other words, if there is no risk of loss then the interest rate can correctly be thought of as the price of time.

In most cases there will, of course, be a risk of loss due to the possibility that the borrower will default or the possibility — if it was money that was exchanged — that the loan will be repaid in terms of money that doesn’t buy as much as it did when the initial exchange took place. In most cases the interest rate will therefore be the price of time plus a premium to account for default risk and “inflation” risk.

Time preference sets a lower limit on market interest rates and time preference will always be positive. The negative interest rates set in place by some central banks therefore have nothing to do with market forces and everything to do with heavy-handed manipulation by people who have far more power than sense.

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