The Free Market Center
The Free Market Center
Fully understanding the function of money interest requires that we first understand more fundamental principles. We must comprehend the distinction between current and future goods; we must understand the concept of time preference; and we must understand the more generalized meaning of interest—as applied to any transaction.
The simple distinction between current goods and future goods plays a critical role in understanding interest in general and money interest in particular.
Now, we can discuss the relationship between time preferences and interest.
An economic good has greater value in the present than in the future—i.e. a fungible good (a good that has all the same physical characteristic at any point in time) has more value in the present than the future. The degree to which the values of current goods exceed the value of future goods depends on the time preference of economic actors.
Even though both will value a future good less than a current good, the actor with a higher time preference places relatively higher values on current goods than will an actor with a lower time preference. Thus, to entice a person with a high time preference (for a particular current good) to exchange it for a similar future good would require a greater quantity of the future good than the same exchange with someone with a low time preference. This fact has a significant influence on lending transactions—i.e. exchanges of future goods for current goods.
Lending transactions consist of the exchange of a current economic good for a greater quantity of an identical economic good in the future – as determined by the time preferences of the parties involved in the transaction. (The concept of interest also applies to exchanges other than lending – e.g. equity investments – but this presentation focuses on lending.) The difference in the number of units of a future economic good that an actor (referred to as a borrower) exchanges for a current economic good determines the amount of interest. The greater the number of units of the future economic good exchanged for the current good the greater the amount of interest.
I think you can better understand the concept of economic interest in terms of something other than money. Say, for example, you want to borrow a pound of sugar from your neighbor. Being the parsimonious person that he is, your neighbor agrees to lend you the pound of sugar, but he says that you must return to him by the end of the month a pound and a half of sugar. When at the end of that month you return the pound and a half of sugar, the half-pound of sugar amounts to interest (By making this offer your neighbor as indicated his willingness to give up the current use of the pound of sugar for the future use of a pound and a half of sugar.)
The rate of interest (or more accurately, the fractional rate of interest) consists of the amount of interest over specified increments of time. (For the mathematically inclined, the fractional rate of interest consists of the slope of the line from the quantity of current goods to the quantity of future goods.)
Since interest rates (fractional rates of interest) are usually calculated on a per annum basis, if your neighbor required you to pay a half pound in interest in one month, the per annum rate of interest would be something on the order of 600%. (i.e., 50% x 12 months).
Prices serve to allocate the use of resources within the same time period. Resources flow – within the same period of time – to uses that offer higher prices. Interest (a form of price) serves to allocate resources based on time preference. Owners of resources will forgo current use when offered a sufficiently large quantity of the same resources in the future. In other words, greater amounts of interest lead to resource uses that have a greater return in the future.
I have described briefly how prices allocate resources in the same time period and interest allocates resources from the present to the future, based on time preference. But what function does interest on money serve?
Since money acts as a medium of indirect exchange, money interest acts as a way to indirectly transfer the use of unspecified resources from the present to the future. The party to the transaction whom we refer to as the lender forgoes the use of goods that he can purchase with that money in the present in exchange for the use of goods that he can purchase with a greater of the amount of money in the future.
Using our neighbor again as an example might clarify this function of money interest. If, instead of a pound of sugar, your neighbor lends you $10 (the hypothetical price of a pound of sugar) in exchange for $15 at the end of a month, he agrees to forgo the use of a number of goods – including sugar – that he could have purchased for $10. To make that exchange he accepts the opportunity to use a number of units of unspecified goods in the future – again including sugar – that he anticipates being able to buy a month from now. Thus, through this transaction he transfers the use of a number of resources – not just the sugar – from the present into the future.
Money interest, therefore, serves to reallocate undefined resources from the present into the future. To achieve this reallocation through time does not require a change in the quantity of money available throughout the system. The flow of money and the level of money prices will accommodate the reallocations of non-money resources. I have demonstrated how this works in the rest of this presentation.