Money is the medium of exchange and store of value on the Economy. People earn money from their work but when someone needs to buy an item or start a business using more money that what he saved he has to ask for a loan. In this situation, money like any other good in the economy has a price which is the interest rate. A lender charges interest in exchange for using his or her money for a period of time. Usually, the interest rate is expressed as a percentage per year, so a loan of $1000 with %10 interest rate means that the borrower will pay $100 per year in interest. Lenders determine the interest rate to charge a certain borrower based on a number of factors:
- The risk associated with the borrower: because people may default on loans causing lenders to lose some or all of their money, lenders try to estimate the risk associated with the borrower and the activity he or she is planning and they demand higher interest rates from riskier people and riskier activities. The term of the loan is also a risk factor, longer term loans get higher interest rates than shorter-term loans.
- The opportunity cost: This is the value the lender is foregoing by giving the money to the borrower. For example, if a lender gets 5% in interest from the bank, he or she will definitely demand higher interest rate to lend the money.
Banks play a major role in the lending market as they play the role of both borrowers and lenders. A bank borrows money from depositors in exchange for interest on their deposits. The bank then uses the deposits to offer loans to borrowers and receives interest from them. A bank makes a profit when the overall income it receives from interest on its loans is more than the interest it pays to its depositors. In a totally free market, interest rates should rise when demand for loans rises in the economy and they should fall when the demand falls.
Central Banks Intervention
Interest rates are not just controlled by the supply and demand forces of the market. Central banks as well have control over the interest rates because they control the supply of money. When central banks create money they increase the available amount of money in the economy pushing the interest rates down.
The following graph shows the history of the Federal Funds Rate which is the rate banks lend each other money to meet their reserve requirements.
The gray areas in the graph represent recessions which are periods of decline in economic activities officially declared when GDP decreases for two consecutive quarters.
Keynesian economists and big government advocates champion easy money policies because they claim they stimulate the economy but in reality, they cause distortion of the market interest rates causing resources to go to unproductive uses. For example, when interest rates are so low people tend to invest their money in assets such as stocks, houses, and cars causing the prices to increase forming a bubble, and when the central bank eventually starts to reduce the money supply to prevent inflation the bubble pops causing a recession. When we examine the graph we will see that several of the recessions happened right after the Federal Reserve started to limit the money supply increasing the interest rates.
It is important to stress that easy money policies are not the cause of the recessions but they make them more severe. Small investment bubbles happen naturally in business when newer investors follow into a new field or trend such as during the late nineties when a lot of people invested in new dot-com companies but easy money policies cause more people to invest in these bubble activities either by obtaining cheap loans or by investing their hard-earned money in them in search for better returns than what banks offer.
Money is a good like any other good in the economy, we should rely on the free market to set the price for it not on a set of experts in central banks who actually never got it right.
Think about a product or a service you bought recently and why you paid that price for it. For example, if you are a Netflix subscriber you pay about $7.99 every month to have access to that service which means that you value having this subscription more than you value $7.99. If Netflix increased its price to $11.99 people who value the service more than $11.99 will continue to subscribe but if Netflix increased the price to $100 a month they will definitely lose a lot of users. People decide to buy a product or a service if they value it more than they value its price that’s why interactions in the free market are all win-win interactions. People won’t voluntarily enter a transaction they don’t think it will make them better off. The decision to buy a product or a service has nothing to do with the cost of production, but it depends on the subjective value the customer puts into that product or service. Economists call this the Subjective Theory of Value.
A producer sets the price of his product or service to what he thinks will attract enough customers to make up for his business costs and get a profit. If a business cannot make a profit it has to make a change such as optimizing its process to save on costs or increasing its prices and hoping to keep enough customers to get profits. If a business couldn’t make a profit it will eventually just shutting down. When a new business enters a market it competes by offering similar value to existing offerings with less price, offering a better value with higher or same price or offering a less value product at a less price point to attract customers who weren’t part of that market. The free market and the different value different people assign to the same product or service allow different options of products and services to suit most customers.
In the free market, a producer cannot ask for a higher price than what the customers value his product while a customer cannot pay less price than what the producer is willing to offer. Some customers and producers try to force outcomes that cannot be achieved via the free market using government coercion. They influence the government to make it interfere in the market by setting prices of certain products or services. Usually, government intervention causes the exact opposite of what the government aimed to achieve:
- Price Ceilings: the government decides that the price of some product or service is high so it sets a ceiling on that price. This leads to increase the demand for that product or service because the low price is less than the value more people place on it. But because it is harder to make the profit under that price many producers will either leave the market or lower the quality of their offerings. Rent Control is a classic example, it leads to increase in the demand for apartments in the city that enacts it and a reduction in the supply of rental units and quality deterioration of the existing units because landlords cut on maintenance.
- Price Floors: the government decides that the price of a certain product or service is low so it sets a floor for the price. This raises the price above what many people value which drives them out of that market leaving much of that product or service unsold. Minimum Wage is a classic example, the government sets the hourly rate of unskilled workers at a rate higher than what many business owners value they don’t higher those workers leaving many of them unemployed.
Politicians use government coercion to interfere in the market to achieve political goals. Although they fail to achieve their stated economic goals, they win the support of voters who wish to buy a product for less than its market price or sell a product for more than its value. The more deviation from the free market they achieve the more problems happen affecting everyone in the economy.