It's no wonder so many get interest so wrong, when they think it's the price of money. Because as Andreas Granath outlines in this guest post, it's actually the price of time ...
Why Interest Rates Are Not the Price of Money
by Andreas Granath
According to mainstream economics, interest rates are the price of money, but the 'Austrian' school of economics says differently. To understand these conflicting ideas, we must understand what prices, money, and interest are.
First of all, prices are exchange-ratios between goods and/or services. An apple might be exchanged for a pear or two bananas. In that case we can conclude that the price of an apple, at that moment, is either one pear or two bananas. However, direct exchange has many disadvantages, and one of them is the price system. Expressing an apple’s price in pears and bananas doesn’t tell a dairy farmer or baker much about his product’s purchasing power. The exchange-ratios (prices) in a barter system are vast, specific, and ever-changing.
Money solves this problem. Since money is a generally-accepted medium of exchange, it is also a common denominator in which we express prices. Suppose that an apple exchanges for $1 (e.g., 1/20th an ounce of gold). Given the above exchange-ratios (prices), a pear would also cost $1 whereas a banana would cost half a dollar. Thus, money prices help agents navigate and communicate better within the economy.
When we have money prices of other goods, we also have a price of money. A seller of goods or services is a buyer of money and vice versa. Money purchases goods and goods purchase money. Therefore, the price of money is inverted to the price of goods and services. If the price of one apple is one dollar, then the price of one dollar is one apple. The price of money is the array of goods for which money can be traded at any given moment. Finding out the overall price of money, however, is not so easy since we need to know all the ever-changing prices in the economy.
Some economists speak of an alteration in the so-called general “price level” and notice when frequently-purchased goods depreciate or appreciate, however, there is no economically meaningful way to define a general price level.
Interest, therefore, is not technically the price of money. But what is interest and why do some economists get it wrong?
According to mainstream economics, interest rates are the price of money, but the 'Austrian' school of economics says differently. To understand these conflicting ideas, we must understand what prices, money, and interest are.
First of all, prices are exchange-ratios between goods and/or services. An apple might be exchanged for a pear or two bananas. In that case we can conclude that the price of an apple, at that moment, is either one pear or two bananas. However, direct exchange has many disadvantages, and one of them is the price system. Expressing an apple’s price in pears and bananas doesn’t tell a dairy farmer or baker much about his product’s purchasing power. The exchange-ratios (prices) in a barter system are vast, specific, and ever-changing.
Money solves this problem. Since money is a generally-accepted medium of exchange, it is also a common denominator in which we express prices. Suppose that an apple exchanges for $1 (e.g., 1/20th an ounce of gold). Given the above exchange-ratios (prices), a pear would also cost $1 whereas a banana would cost half a dollar. Thus, money prices help agents navigate and communicate better within the economy.
When we have money prices of other goods, we also have a price of money. A seller of goods or services is a buyer of money and vice versa. Money purchases goods and goods purchase money. Therefore, the price of money is inverted to the price of goods and services. If the price of one apple is one dollar, then the price of one dollar is one apple. The price of money is the array of goods for which money can be traded at any given moment. Finding out the overall price of money, however, is not so easy since we need to know all the ever-changing prices in the economy.
Some economists speak of an alteration in the so-called general “price level” and notice when frequently-purchased goods depreciate or appreciate, however, there is no economically meaningful way to define a general price level.
Interest, therefore, is not technically the price of money. But what is interest and why do some economists get it wrong?
It might be better said that interest is the price of time. It is the premium some people pay for not being able to wait, as well as the discount some people get for being able to wait.
Interest is best explained by the concept of time preference, which means that people necessarily prefer present consumption more than future consumption. Suppose that John Smith wants to buy a house that he cannot yet afford. Since Smith has a very high time preference, he doesn’t even bother saving some money. Instead, he asks his cousin if he can borrow $100,000. Although his cousin values having his $100,000 stuffed under his mattress, he agrees to loan Smith his money. However, because of the sacrifice of not having access to the money in the present, he charges his cousin an interest premium of $105,000.
By observing this transaction, we can draw some conclusions. First, the price of the $100,000 in this case was one house. Second, the price of the loan provided was the 5% interest rate that amounted to $5000 in this case. Finally, suppose the money with which Smith paid back the loan was money he had earned from labor. In that case, the price of $105,000 was the amount of labor hours for which Smith was paid wages.
That said, many economists interpret this observation in the following way: since $100,000 can be exchanged for $100,000 today, the price of a dollar is a dollar. However, since the interest rate over a year is 5%, the price of today’s dollar is priced at 1.05 dollars-in-a-year. Hence, the conclusion that the interest rate is merely the “price” of money.
To sum up, I would like to end with a quote from an article on this same subject from economist Nicolás Cachanosky. He writes:
Interest is best explained by the concept of time preference, which means that people necessarily prefer present consumption more than future consumption. Suppose that John Smith wants to buy a house that he cannot yet afford. Since Smith has a very high time preference, he doesn’t even bother saving some money. Instead, he asks his cousin if he can borrow $100,000. Although his cousin values having his $100,000 stuffed under his mattress, he agrees to loan Smith his money. However, because of the sacrifice of not having access to the money in the present, he charges his cousin an interest premium of $105,000.
By observing this transaction, we can draw some conclusions. First, the price of the $100,000 in this case was one house. Second, the price of the loan provided was the 5% interest rate that amounted to $5000 in this case. Finally, suppose the money with which Smith paid back the loan was money he had earned from labor. In that case, the price of $105,000 was the amount of labor hours for which Smith was paid wages.
That said, many economists interpret this observation in the following way: since $100,000 can be exchanged for $100,000 today, the price of a dollar is a dollar. However, since the interest rate over a year is 5%, the price of today’s dollar is priced at 1.05 dollars-in-a-year. Hence, the conclusion that the interest rate is merely the “price” of money.
To sum up, I would like to end with a quote from an article on this same subject from economist Nicolás Cachanosky. He writes:
...if you get money and pay interest, eventually the day will come when you have to return the amount of money (plus interest.) If you have to return it, then you didn’t buy the money and so the interest rate is not the price of buying money.
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His piece previously appeared at the Mises Wire.
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