According to the writings of Carl Menger and Ludwig von Mises, the driving force of interest rate determination is individual’s time preferences.
What is this all about?
As a rule, people assign a higher valuation to present goods versus future goods. This means that present goods are valued at a premium to future goods.
This stems from the fact that a lender or an investor gives up some benefits at present. Hence, the essence of the phenomenon of interest is the cost that a lender or an investor endures.
On this Mises wrote,
That which is abandoned is called the price paid for the attainment of the end sought. The value of the price paid is called cost. Costs are equal to the value attached to the satisfaction which one must forego in order to attain the end aimed at.1
According to Carl Menger:
To the extent that the maintenance of our lives depends on the satisfaction of our needs, guaranteeing the satisfaction of earlier needs must necessarily precede attention to later ones. And even where not our lives but merely our continuing well-being (above all our health) is dependent on command of a quantity of goods, the attainment of well-being in a nearer period is, as a rule, a prerequisite of well-being in a later period. … All experience teaches that a present enjoyment or one in the near future usually appears more important to men than one of equal intensity at a more remote time in the future.
Likewise, according to Mises,
Satisfaction of a want in the nearer future is, other things being equal, preferred to that in the farther distant future. Present goods are more valuable than future goods.2
An individual who has just enough resources to keep him alive is unlikely to lend or invest his paltry means.
The cost of lending, or investing, to him is likely to be very high — it might even cost him his life if he were to consider lending part of his means. Therefore, under this condition he is unlikely to lend, or invest even if offered a very high interest rate.
Once his wealth starts to expand the cost of lending, or investing, starts to diminish. Allocating some of his wealth towards lending or investment is going to undermine to a lesser extent our individual’s life and wellbeing at present.
From this we can infer, all other things being equal, that anything that leads to an expansion in the real wealth of individuals gives rise to a decline in the interest rate, i.e., the lowering of the premium of present goods versus future goods.
Conversely, factors that undermine real wealth expansion lead to a higher interest rate.
Time Preference and Supply Demand for Money
In the money economy, individuals’ time preferences are realized through the supply and the demand for money.
The lowering of time preferences (i.e., lowering the premium of present goods versus future goods on account of real wealth expansion) will become manifest in a greater eagerness to lend and invest money and thus lowering of the demand for money.
This means that for a given stock of money there will be an increase in the excess supply of money.
To get rid of the excess, people start buying various assets, in the process raising asset prices, and lowering their yields, all other things being equal. Hence, the increase in the pool of real wealth will be associated with a lowering in the interest rate structure.
The converse will take place with a fall in real wealth. People will be less eager to lend and invest, thus raising their demand for money relative to the previous situation.
This for a given money supply reduces the excess money. Consequently, all other things being equal this lowers the demand for assets and thus lowers their prices and raises their yields.
What Central Banks Intervene
What will happen to interest rates because of an increase in money supply? An increase in the supply of money, all other things being equal, means that those individuals whose money stock has increased are now much wealthier. Hence, this sets in motion a greater willingness to invest and lend money.
The increase in lending and investment means the lowering of the demand for money by the lender and by the investor. Consequently, an increase in the supply of money coupled with a fall in the demand for money raises the excess supply of money, which in turn bids the prices of assets higher and lowers their yields.
As time goes by the rise in price inflation starts to undermine the well-being of individuals and this leads to a general rise in time preferences. This lowers individuals’ tendency for investments and lending (i.e., raises the demand for money and works to lower the excess money supply growth rate), and this puts an upward pressure on interest rates.
In a market economy, within the framework of a central bank, the key factor that undermines the pace of real wealth expansion is the monetary policy of the central bank. It is loose monetary policy that undermines the stock of real wealth and the purchasing power of money.
We can thus conclude that a general increase in price inflation, because of an increase in money supply and a fall in real wealth, are factors that set in motion a general rise in interest rates. A general fall in price inflation in response to a fall in money supply and a rise in real wealth are factors that set in motion a general fall in interest rates.
Furthermore, an increase in the growth momentum of money supply sets in motion a temporary fall in interest rates. Meanwhile, a fall in the growth momentum of money supply sets in motion a temporary increase in interest rates.
Note again that changes in excess money supply mirror the interaction between changes in supply – demand for money.