Home > Economics > The interest rate is not the price of money

The interest rate is not the price of money

(Just a quick one, on a topic I am still highly uncertain and confused about. So be nice.)

I’ve been taught no less than three times that the interest rate is the price of money: once at school, once at college and once again at CFA class. And that doesn’t seem right to me.

First, consider a world without money. I offer you one sheep in exchange for two this time next year. The interest rate is 100%. It expresses the rate at which consumption can be shifted through time.

Second, consider a world where everyone adhered to Polonius’ admonition to neither a borrower nor a lender be. There is still money in this world. It is traded for goods and services. The price of money is the rate at which it is traded for goods and services. That is to say, it is what we normally call ‘the price level’.

So money is not essential to the existence of interest rates, and interest rates are not essential to the existence of money. As the medium of exchange, the price of everything is expressed in terms of money. There is no more a case for the price of future consumption being “the” price of money than the price of kumquats. A price is nothing more and nothing less than the rate at which things are exchanged, and money can be exchanged for anything. Considering this, I find it hard to see why setting an interest rate is the ‘essence’ of monetary policy, because it’s just one price among many. That we do it this way just seems like a historical accident.

This is also by way of saying that while I understand the zero-lower-bound issue under the current monetary system, the reason why it’s an issue at all is because normal monetary operations revolve around exchanging an asset that, under certain circumstances, becomes highly substitutable with money*.

Maybe we should choose a different one.

_______________________________________________________________________________________________________

*This is also the only way I have been able to understand the ‘QE is just an asset swap’ objection, but that could be as much to do with my feeble brain as the quality of explanation on offer

About these ads
Categories: Economics
  1. Max
    April 24, 2012 at 5:36 pm | #1

    If the central bank just sets the bank interest rate, then there’s a clean separation between monetary policy and fiscal policy. If the central bank starts acting like a real bank, taking credit risk, then its operations have fiscal effects – it will show a profit or loss on the investments. And even if it makes a profit, some people will complain that the actions display favoritism (“bail out”)…it’s inherently more controversial than interest rate setting.

  2. david
    April 27, 2012 at 9:30 pm | #2

    The interest rate is the price of liquidity, which normally is a perfect substitute with money.

  3. Eldar
    April 8, 2013 at 5:43 pm | #3

    I have the same confusion! if money is the medium of exchange, how can it has a price? say, how much is 100$? I know that trough the time, inflation (that always exists) weakens currencies, OK! the holder who can take risk and invest his/her money or change it to capital/assets. Lending is the easiest way to escape the risk (not completely).

  4. April 30, 2013 at 9:26 pm | #4

    Very good article. I will be facing some of these issues as well.

    .

  5. May 1, 2013 at 2:49 am | #5

    Have you ever thought about writing an ebook or guest authoring on other sites?

    I have a blog centered on the same information you discuss and would really like to
    have you share some stories/information. I know my visitors would enjoy your
    work. If you are even remotely interested,
    feel free to send me an e-mail.

  6. May 1, 2013 at 3:51 am | #6

    Hi, i think that i saw you visited my site thus i came to “return the favor”.
    I am trying to find things to improve my site!I suppose its ok to use some of
    your ideas!!

  7. May 1, 2013 at 1:15 pm | #7

    I’m not that much of a internet reader to be honest but your blogs
    really nice, keep it up! I’ll go ahead and bookmark your site to come back later. Cheers

  8. May 1, 2013 at 1:22 pm | #8

    Highly descriptive post, I loved that a lot. Will there be
    a part 2?

  1. No trackbacks yet.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

Follow

Get every new post delivered to your Inbox.

%d bloggers like this: