EKIP– Expert Club for Economics and Politics A Different Opinion
According to mainstream economics, the central bank is the key factor in determining the level of interest rates. By setting short-term interest rates and based on expectations about the future course of its interest rate policy, it influences the entire structure of interest rates. It follows that economic players have almost no involvement in this process and simply mechanically adjust their expectations about the future policy of the central bank.
The individual's time preference
Some of the most prominent representatives of the Austrian School of Economics, namely Carl Menger and Ludwig von Mises, offer another reading of the situation and come to the conclusion that the driving force in determining the interest rate is not the central bank, but the time preferences of the individual. A good in the present is of higher value to the individual compared to the same good, but at a future time point. This means that current goods are valued at a premium compared to future goods. This arises from the fact that a lender/creditor gives up some benefits in the present and requires a future premium in order to provide a loan to the borrower.
Let us take a hypothetical example of an individual who has only enough money for his physical survival. It is very likely that he will not be willing to give up his meager means. The price (the benefits he forgoes) that he would pay could even cost him his life, and therefore even if he were offered a very high interest rate, he would most likely not lend to anyone. At a time when there is an increase in his wealth, allocating part of his wealth for lending would affect his life and well-being to a lesser extent. From this we can conclude that everything that leads to an expansion of the real wealth of individuals also leads to a decrease in the interest rate (i.e., to a decrease in the premium of current goods over future ones). Conversely, factors that undermine the expansion of wealth lead to a higher interest rate.
Time preference and the demand for money
In a monetary economy, individuals' time preferences are realized through the demand and supply of money. A decrease in time preferences (i.e., a decrease in the premium of present goods over future goods) influenced by an increase in wealth will lead to a greater willingness to lend and invest money, and thus to a decrease in the demand for money.
The opposite will happen with a decline in real wealth. People will be less willing to lend and invest, thus increasing their demand for money compared to the previous situation. Other things being equal, there is a decline in monetary liquidity and the demand for other assets, thus the prices of the latter fall and the yields rise.
What will happen to interest rates as a result of an increased money supply? An increase in the money supply means that individuals with a net increase in their money holdings are richer. Therefore, they are more willing to invest and lend. An increase in lending and investment means a decrease in the demand for money by the lender/investor. Therefore, an increase in the money supply, combined with a decrease in the demand for money, leads to a money surplus, which in turn leads to higher asset prices and lowers their yields.
Over time, a rise in price inflation, driven by an increase in the money supply, begins to erode people's well-being and leads to a general increase in their time preferences. This in turn reduces the latter's propensity to invest and lend, i.e. increases the demand for money and reduces the money surplus, putting upward pressure on interest rates.
Monetary policy and real wealth
In the modern economy, the key factor influencing the rate of real wealth growth is the monetary policy of the central bank. Loose (low interest rates) monetary policy reduces real wealth and the purchasing power of money. We can conclude that an increase in price inflation as a result of an increase in the money supply and a subsequent decrease in real wealth is a factor that sets the stage for a general increase in interest rates. Conversely, a decrease in price inflation as a result of a restrictive monetary policy and an increase in real wealth prompts a decrease in interest rates.
