The Role of Interest Rates in a Market Economy.

saving and spending

saving and spending (Photo credit: 401(K) 2012)

Do interest rates determine the amount of savings or does the amount of savings determine the interest rate?

We place a higher value on possession of a good or service in the present then possession of the same good or service at some point in the future. Unlike a good or service, paper money has no use value, other than use for starting a fire if you are cold or toilet paper if you run out. It’s only value is in exchange. Money is certificates of purchase, and can be exchanged for any good or service at any time, therefore we value money in the present more then we value money in the future. Money represents the ability to acquire a good or service you desire, it is not the good or service.

The premium we place on present goods compared to future goods, or put differently, the discount we place on future goods compared to present goods is the interest rate. The time preference of all individuals determines the interest rate. As the amount of savings rises the interest rate goes down and as the amount of savings shrinks the interest rate goes up, according to the law of supply and demand.

The interest rate, which is the ratio of the discount of future goods to present goods or the ratio of the premium of present goods to future goods, sends signals through the market. When the interest rate is falling we are saving more and consuming less, which means resources are being saved for future consumption. When the interest rate is rising we are consuming more and saving less, which means resources are being used for present consumption.

Resources are scarce and have many uses. This is the first rule of economics. Low interest rates send a signal to producers that resources are being freed up for use in future lines of production. The cost of expansion for future production is now economical because of the low-interest rate. Higher interest rates sends a signal to producers that resources are being used for present consumption. The cost of expansion for future production is too costly because of the higher interest rate. This complex structure of production is the result of the coordination of each individuals unlimited desire for specific goods, their time preference for specific goods, constrained by the scarcity of resources, the different uses for resources, and the desire of individuals to produce specific goods based on whether they think it’s profitable. The interest rate coordinates production across time if it is determined by the market i.e. individuals time preferences. If set arbitrarily, it throws a wrench into the spokes of the production process.

What happens when the Federal Reserve intervenes into this complex process? Fed policies usually result in artificially low-interest rates, and the injecting of electronically printed money into the system. The policy sends mixed signals through the market. If money is counterfeited and supplied to banks it represents more savings which lowers interest rates (supply and demand). The false signal is sent, there are more resources for expansion, but people are still consuming at their present rate and haven’t started saving more for future production. The structure of production is being pulled in two different directions. The counterfeit money is bidding for the use of scarce resources for future production, but the structure of production is set up to meet people’s desire for present consumption. This is what happened with the housing bubble. Resources, labor, capital, and time were pushed into areas they wouldn’t have been under normal market conditions, and were wasted as the bubble became unsustainable and collapsed. The Federal Reserve and all Government bureaucrats don’t have a fraction of the knowledge that the market can bring to bear on any decision, but they have enough arrogance to think they do. As Hayek says their “pretense of knowledge” makes them think they can bring about results that aren’t possible because they fly in the face of the most basic economic principles.

For more in-depth reading on interest rates read this article by Frank Shostak at Mises.org.

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