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No, the interest rate is not the price of money

February 9, 2015
in Blog

The notion that the interest rate is the price of money is seriously misled. As I move forward with my lectures on the Keynesian system, this is something that I want to make clear to my students. Certainly, when evaluating the Keynesian model, we need to understand what the model says (and what it does not say), but unfortunately, textbooks do not always tackle controversial issues. This is an example of the perpetuation of errors and misconceptions by textbooks. To see this for yourself, simply open a random macroeconomics textbook and read what it has to say about the classical economists– then, open a book actually written by a classical economist and compare what the two have to say.

It should be clear that the interest rate is not the price of money. For starters, if you get money and pay interest, eventually the day will come when you have to return the amount of money (plus interest.) If you have to return it, then you didn’t buy the money and so the interest rate is not the price of buying money.

But more significantly, a few scenarios that have to do with interest rates but not money come to mind. Let’s say that I lend you 10 apples on condition that you will return 11 apples to me one year from now. There is a 10 percent interest rate, but no money involved. If we are not ready to say that the interest rate is the price of apples, then for the same reason we should not be ready to say that the interest rate is the price of money. The other characteristic that this example illustrates is that the interest rate is not a monetary phenomenon. It is, in fact, a time phenomenon. The interest rate is the price of time, or credit, but not the good in which the credit takes place. Certainly, it is easier for individuals to take out loans in money than in apples. In the latter case, you have to sell the apples, get the money, do your business and then buy the apples with interest and return them to me. But the fact that it is easier to make loan transactions in the form of money does not make interest rates the price of money. In other words, (subjective) time preference is to interest rates what (subjective) marginal utility is to prices.

Why, then, such confusion about interest being the price of money in the Keynesian system? Really, it’s because of how the model is constructed. In the Keynesian system, wealth is divided only into two types of assets: (1) money and (2) bonds. Then, an increase in the demand for money (assume that wealth is constant) means that the individual or firm sells bonds to get more cash in his portfolio. All else equal, the price of the bond falls and therefore the interest rate increases. Higher demand for money means higher interest rates. This is the relationship we should expect between a good and its price. But the bond also has a market price, which fell. If the price to buy a bond is P, then the price of money in terms of bonds is 1/P. Yes, the way the Keynesian system is built leads one to think of the interest rate as the price of money, but there is no need to fall in this trap.

The difficulty with the price of money is that money is the unit of account, and its price does not come in a clear unit of account, but rather in how many goods (from a defined basket) need to be sold to buy one dollar. The inverse to the operation of buying goods by selling money is to buy money by selling goods. Then, the price of the good in terms of money (p) and the price of money in term of goods (1/p) are the inverse of each other.

3 Comments

  1. Joachim December 21, 2016 3:00 AM

    Hey, Nicolas! I have a question unrelated to the post itself but related to the subject
    According to the keynesian model, the interest rate (lets call it i) is determined by the money demand (Md) given a specific money supply (Ms). How is it determined according to the Austrian School of economics (or any non-keynesian school of thought)?
    I would love if you could provide a technical explanation. Im majoring in economics but all we get is keynes.
    Thanks in advance,
    Joachim.

  2. Nicolas Cachanosky February 11, 2015 3:09 PM

    I don't see, actually, how am I not saying that the price of "money" and the price to "rent money" are two different things. Surely I don't use those terms, but is not that what the post is saying?

    Now, I don't use those terms because I find to talk about the price of "money" and price to "rent money" confusing or misleading. Interest rate, the way I see it, is the price of credit, in whatever form or commodity credit is channeled. Surely, credit in different commodities (money, apples, etc.) would have different components that would result in different interest rate values. But what is common to all interest rates is the time preference, the price of time as it where.

    I have no problem with anyone talking about the price to rent money, or even the price of money, if it's clear the meaning attached to those expressions. In my experience, this is not how the topic is presented to students in most textbooks. Without a proper explanation, I find the term "rental price *of money*" misleading, whoever it comes from, especially because the interest rate is not a monetary phenomena, but a time phenomena. Doesn't this terminology contribute to such a long-lasting confusion?

  3. robert barsky February 9, 2015 3:51 PM

    This is an improvement on the most egregiously bad expositions one can find in old textbooks and other forums, but it goes only a bit of the way toward a proper professional analysis. The correct analysis is that their are *two* prices associated with money: the "purchase price" and the "rental price". As Professor Milton Friedman always stressed, the *purchase price* of money is the inverse of the general price level, i.e. 1/p, where p is the price of the "average" good. To possess a dollar forever, one has to give up a quantity of goods equal to 1/p. The *rental* price of money, on the other hand, the cost of holding (non-interest-bearing) money for one year and then returning it to the lender or using it to purchase goods, is indeed the nominal interest rate. This failure to understand that many goods have both purchase and rental prices – and the related concept that there is often both a stock and a flow equilibrium (the holding of existing stocks of commodities as compared with the supply-demand balance between new production and absorption of the new supplies) is behind many of the failures of naive would-be economists. Robert Barsky, Professor Emeritus, University of Michigan, Ann Arbor.