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.