If there is one thing about the Keynesian model that drives me to near insanity is the inherent misinformed assumption that the interest rate is the price of money. And because of Keynes influence, this general misconception has become very widespread. But his model – and beliefs – do not necessarily ground this as fact, it’s just the way the model is setup.
Why The Interest Rate is Not The Price of Money
In the Keynesian system, there are only two assets. These two assets are 1) money and 2) bonds.
If we would assume an increase in the demand for money (under this system), then everyone would sell bonds to raise their financial holdings. Since a lot of people would sell bonds, the price of the bonds would go down. If the price of bonds decrease, the interest rate would have to increase.
Thus, higher demand for money would transition to higher interest rates.
There is a key point left out here, however. The price for bonds fell. Which means if the price to buy a bond is f(x), then the price of money in terms of bonds is 1/f(x). So if you have a basic math background, you could intuitively deduct that the price of these bonds in terms of money (f(x)) is actually the inverse of the price of money in term of goods (1/f(x)).
Let’s try this in non-math terms:
Let’s say you borrow money from a friend ($100), and he asks for it back in a month with an extra $10. Assuming you’re a good friend, when a month rolls around you’ll have to give him back the original $100 plus $10. This means that you did not buy the money, because you have to give it back. So the 10% interest rate is not the price of buying the money, because you have to return it.
We can make it even more obvious. Once again let’s say that I give you 2 water bottles with the condition that tomorrow you give me 4. An interest rate of 100%. Would you say that the interest rate is the price of water bottles? Of course not – it would not make any sense. The price of the water bottles is a completely separate topic, that we can not determine from the given information.
So what is the interest rate?
Simply put: it’s the price of time.
Consider our water bottle example above. Which should hopefully make it apparent that the interest rate is applied based on time. I give you 2 water bottles now, so I can have 4 later. You desire to have them today, whereas I would rather have more later. It’s all about time.
When dealing with an interest rate question (whether financially or economically) it definitely helps to remember this. If you’re the borrower, you get something immediately, but are expected to return it at a later time with interest added. The time horizon, and the marginal utility you derive from acquiring the good at specific time intervals, is how the interest rate should be considered and viewed.
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2 Comments on "The Interest Rate Is NOT The Price Of Money"
Nice clarification article. I’d be hesitant to say that the price of goods is always an inverse, however.
Thanks! I was hoping that in the context of that example, it was obvious.