Time Preference Is the Key Driver of Interest Rates
By popular thinking, whenever the central bank raises the growth rate of the money supply through the buying of financial assets such as Treasuries this pushes the prices of Treasuries higher and their yields lower. This is labeled as the monetary liquidity effect. This effect is inversely correlated with interest rates.
Furthermore, an increase in the money supply after a time lag strengthens economic activity and this pushes interest rates higher. Note that we have here a positive correlation between economic activity and interest rates.
After a much longer time lag, the increase in the growth rate of money supply is starting to exert an upward pressure on the prices of goods and services. Once prices begin to move higher, the inflation expectations effect emerges. Consequently, this is starting to exert a further upward pressure on the market interest rates.
Hence, by popular thinking, liquidity, economic activity, and inflation expectations are seen as key factors in the interest rate determination process. Observe again that this process is set by the central bank’s monetary policies, which influences monetary liquidity. The monetary liquidity effect in turn gives rise to two other effects. This way of thinking originates from the writings of Milton Friedman.
Note that the popular theory of the interest rate is not established from a theoretical framework that “stands on its own feet” but derived from observation. In this sense, the popular theory of interest rate does not explain it only describes. According to Ludwig von Mises,
What economic history, observation, or experience can tell us is facts like these: Over a definite period of the past the miner John in the coal mines of the X company in the village of Y earned p dollars for a working day of n hours. There is no way that would lead from the assemblage of such and similar data to any theory concerning the factors determining the height of wage rates.
Furthermore, the popular theory cannot explain the formation of interest rates in the absence of the central bank.
Time preference and interest rates
For most individuals, maintaining their life and well-being is the ultimate goal. 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 c
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