jmherbenerThe interest rate is the inter-temporal price of money, i.e. the exchange ratio between present money and future money. Fundamentally, it is determined by people’s time preferences, i.e., their preferences for a given satisfaction sooner instead of later. The interest rate is manifest in two ways. First, the contract rate of interest for credit transactions and second, the price spread between output prices and input prices in production.
The total stock of money and the total demand for money determine money’s purchasing power, which is the inverse of the prices of goods.
The exchange rate between different moneys adjusts to keep the purchasing power of any one money the same everywhere. So if the demand for the dollar increases, with the money stock the same, the purchasing power of the dollar will increase. This means both that prices will fall domestically and that the dollar will appreciate internationally.
The demand for money and time preferences are independent of each other. They refer to two different ends and actions to attain those ends. Time preference is the preference to attain a given satisfaction sooner instead of later. A person acts inter-temporally to satisfy his time preferences. If his time preference is low he lends to someone with higher time preference and earn the rate of interest. The demand for money is the preference to retain money balances, instead of lending them, for the purpose of dealing with uncertainty.
The interest rate would not be directly affected by high demand for money or low demand for money. If demand for money were high, then the purchasing power of money would be high, i.e., prices of goods would be low. If the demand for money were low, then the purchasing power of money would be low, i.e., prices of goods would be high. But the price spread between output prices and input prices need not be affected. Suppose an iPad Air sells for $500 and has costs of $450 for a price spread of $50. If money demand increased sufficiently, then the iPad Air might sell for $250 but the entrepreneurial demand for inputs would also fall and so costs wind up at $225 and the price spread of $25 renders the same rate of return.
Money is neither “easier to come by” in periods of price inflation nor “harder to come by” in periods of price deflation. It’s precisely the change in the purchasing power of money that make any stock of money suitable to perform all exchanges in society. The increased stock of money during inflation induces no surplus of money because people use it to increase their demand goods, which bids up their prices. At the higher prices, they spend more money but are just able to buy the goods offered for sale. And the reduced stock of money during deflation induces no shortage of money because people reduce their demand for goods, which lowers their prices. At the lower prices, they spend less money but are just able to buy all the goods offered for sale.
If a change in the purchasing power of money is unanticipated by people, then the rate of price inflation or deflation will affect the price spread between output prices and input prices and market rate of interests will be higher or lower, respectively. But this does not affect people’s time preferences.