How interest rates are set

Supply and demand

To understand how interest rates are set, you should know the law of supply and demand. This law is simple. As the price of an item rises demand goes down and supply goes up. If coffee is expensive, some people may not be able to buy coffee. Others might decide to take an energy drink because that is cheaper. And so demand goes down. On the other hand, some farmers might decide to switch to growing coffee because it can bring them a bigger profit than the crop they are growing currently. And so supply goes up even though it may take a while before the extra coffee becomes available.

As the price of an item falls, demand goes up and supply goes down. If coffee is cheap more people can afford it and those who opted for energy drinks might choose coffee instead. And so demand goes up. On the other hand, some farmers that grow coffee might decide to switch to growing another crop because they think it will them bigger profits. And so supply will fall even though it may take a while. In this way there is a price where supply equals demand. For example, for a certain item demand and supply might equal 1,200 items when the price is € 7.

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The price of money

If the price of book is € 7 in France then what does that mean? The same book might cost $ 8 in the United States. Is the item more expensive in the United States than in France? That depends on the price of the dollar and the euro. If the dollar is worth € 0.80 then $ 8 is cheaper than € 7. The price of the euro and the dollar change every day because of changes in supply and demand in the market for euros and dollars.

When economists discuss the price of money, they mean the interest rate, not the price of dollars and euros. The supply and demand for borrowed money determine the interest rate. When many people want to borrow money or when there isn’t much money available for lending, the interest rate goes up. When only a few people want to borrow money or when there is a lot of money available for lending, the interest rate goes down.

So what determines the supply and demand for money and therefore the price of money? Economists have put a lot of thought into this question. According to them interest rates are determined by convenience, risk, returns on investments, time preference, and capitalist spirit. These things will be explained shortly. The type of money we use can also influence interest rates.

Convenience

When you have lent your money to someone else, you can’t use it yourself. There may be a new mobile phone in the shop that you desperately want to buy, but alas, you have lent out your money. This is not very convenient. But then you remember with a smile on your face that you will be able to buy the phone, and a hip phone cover too next year, because you receive a nice interest rate on this loan. So, if people don’t receive interest on their money, they may not bother lending it out because they may need it.

When you deposit money at a bank, you lend it to the bank but you can still use it any time you want. The bank can do that because if you make payment, for example for legal advice, this money ends up the account of the lawyer, and the bank will be borrowing this money from the lawyer instead, until she uses it to pay someone else. That is very convenient. For that reason interest rates on current accounts and checking accounts are low. Having money in a current account is more convenient than cash so the bank may even charge you for that.

Risk

Lending out money can be risky. There are two types of risk. First the borrower may not pay back the loan. That could make you reluctant to lend out your money. So if someone wants to borrow money from you, and you fear that she may not pay back, she could offer you a high interest rate on the loan so that you might think, “Well, there is some chance that she will pay back, and the interest rate is very attractive, so I’ll do it.”

Second, money may become worth less in the future. This is called inflation. If there’s a lot of inflation then the money that buys a mobile phone today may only buy a phone cover a few years later. In that case you may spend your money right away on a mobile phone before it is too late. That is unless someone wants to borrow the money from you and offers a very high interest rate, so that your can buy a newer model next year.

The business of a bank is to know its customers. For that reason lending money to a bank is less risky than lending out money to an individual or a corporation yourself. And because banks are supposed to be good at managing risk, they can borrow at lower interest rates. And because they know their customers well and lend to many different customers, they can also lend at lower interest rates than you could.

Returns on investments

If you have some money, you could invest it in corporations or real estate. Corporations pay dividends and real estate pays rent. If the rents and dividends are higher than the interest rate you get when lending out money, you may prefer to invest your money. But investing is more risky than lending. If sales are sluggish, dividends may be cut, but lenders will still get their interest. And when a business goes bankrupt, lenders will get back their money fist. Investors only get what’s left over.

If someone wants to borrow money from you, the interest rate must be attractive, otherwise you may prefer investing and receiving dividends and rents. Other people that have money are in a similar position. Borrowers need to offer attractive interest rates in order to be able to borrow any money. Similarly, if dividends and rents are low, people with money may prefer lending to investing, so that borrowers do not have to pay high interest rates. In this way the returns on other investments affect interest rates.

Time preference

Suppose that you are a hatter and just received € 50 for a hat. You could rush to the nearest phone shop and buy that phone cover you saw yesterday. Alternatively, you could save the money so that you could buy a mobile phone later when you have sold more hats. You could even save some money for retirement. Choices are abundant, but the odds are that the money will be gone before the month is, and that you have acquired the phone cover or some other gewgaw. Most people spend their money sooner rather than later, and even borrow some more. Economists will diagnose you with a condition called “time preference”.

What has this to do with interest rates? It is the law of supply and demand. Suppose that you want that latest model mobile phone and only have the money for a phone cover, so you want to borrow some money. In that case someone else needs to save some money and lend it to you. But he wants to buy that latest model mobile phone too, so only an additional hip phone cover might convince him to wait. The law of supply and demand is at work here. When more people want to borrow or fewer people want to lend, the price of money, which is the interest rate, rises.

This is because time preferences differ for different people. Mary may save money if interest rates are above 4% and borrow once interest rates are lower. John may save money as long as interest rates are above 6% and borrow if interest rates are lower. Alex might save if interest rates are above 5% but he may not borrow if interest rates are lower. As interest rates rise, the supply of funds for lending goes up and the demand for funds for borrowing goes down. The interest rate in the market will then be where supply equals demand.

Capitalist spirit

Time preference only works for ordinary people. There are other people too. They are called capitalists. Capitalists think differently. Economists have diagnosed them with a condition called “capitalist spirit”, which is the opposite of “time preference”. Capitalists think that money spent on a frivolous item is money wasted. That is because if you invest your money, you will end up with more money that you can invest again.

Capitalists don’t suffer from time preference. They save and invest anyway. Consequently capitalists end up with a lot of money when they die. What’s the point of that? Capitalists invest in businesses that make the frivolous items ordinary people enjoy. Ordinary people wouldn’t have invested their money, but spent it instead on frivolous items, so that these items wouldn’t have been produced in the first place.

Capitalists have a lot of money they need to invest because of their capitalist spirit. They don’t stop saving and investing when interest rates go lower. If they are running out of things to invest in, they are willing to lend it at lower interest rates. Again, it is the law of supply and demand at work here. If capitalists have a lot of money while other people can’t borrow more because they can’t pay the interest, interest rates go down.

The type of money used

The properties of money can affect interest rates. Just imagine that apples are money and you are saving to buy a house. If someone wants to borrow 1,000 apples from you, and promises to repay those 1,000 apples after 10 years when you plan to buy your house, you would gladly accept this generous offer. You may even have accepted an offer of 900 apples because that is better than letting your apples rot. In this case you would settle for a negative interest rate. But you would only do so if there are no alternatives.

If you could make 10% per year in the stock market, you could exchange your apples for Apple stock because their gadgets are in great demand and outrageously expensive. In that case, it doesn’t matter that the apples rot, and you could demand interest on a loan. But if returns on the stock market are low or when stock prices are fluctuating so wildly that you can’t sleep at night, you may prefer the offer of 900 apples.

If the money had been gold, you would never accept such an offer, even when the stock market is doing terrible. If interest rates are negative, you can always keep your gold in a safe deposit box. Similarly, you wouldn’t accept negative interest rates on euros or dollars because you can take bank notes and store them in a safe deposit box. The problem with this is that if you put money in a safe deposit box other people can’t use it for buying and selling stuff. And this can cause an economic depression.

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US real interest rate versus natural interest rate

The future of interest rates

Economists and central bankers think that low and negative interest rates will be temporary but the graph above tells a different story. It shows the interest rates in the United States between 1961 and 2016. The green line is the real interest rate in the market. A real interest rate is the inflation free interest rate. So if the interest rate of you mortgage is 5% and the inflation rate is 2%, the real interest rate on the mortgage is 3%.

The red line is the natural interest rate. This is the ideal interest rate for optimal economic growth. The natural interest rate is not an interest rate in the market. It is estimated by economists using models. Central banks use the natural interest rate to set the interest rate. If the central bank believes that the economy is overheating, it sets the interest rate above the natural rate. If it believes that the economy is in a slump, it sets the interest rate below the natural rate.

The trend is clear but most economists and central bankers expect that interest rates will go up again. Only, the developments that drove interest rates down may not go away and interest rates may remain low and may even go lower. This has something to do with capitalist spirit. Interest rates have mostly been higher than the economic growth rate and most interest income has been reinvested because of the capitalist spirit, so that a growing part of total income was for investors.

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Interest income (red) versus total income with interest income growing faster than total income

It is the law of supply and demand at work. The amount of available capital grows faster than the demand for capital so that the price of capital, which is the interest rate, must go down. In a capitalist economy people with lower time preferences than the prevailing interest rate tend to save and invest, while people with a higher time preference tend to consume and borrow. At some point the people with the higher time preferences pay a lot in interest and can’t borrow any more, so that they have less money to spend.

The economy then slows down because people can’t afford all the stuff corporations make. Interest rates go down because the capitalists can’t find good investments so that they are willing to accept lower interest rates. Then people with a somewhat lower time preference start to consume and borrow. This works for a while until they can’t borrow more. This cycle repeats again and again as interest rates go lower. More and more people go into debt because their time preferences exceed the interest rate.

This doesn’t suddenly change when interest rates reach zero. If interest rates go lower, capitalist may lose money, but if they suffer from capitalist spirit, small losses may not deter them from saving and investing. And if people can borrow money at negative interest rates from the capitalists, capitalists may be better off because their corporations will be more profitable. Interest rates may go lower until the amount of capital doesn’t grow faster the economy and then things find a balance.

In the long the run capital can’t grow faster than the economy. This puts a constraint on interest rates. If all interest income is reinvested, the average interest rate can’t exceed the economic growth rate.