[gmorin]

Dr. Herbener,
I was the one that asked the question during the last video session about an apparent paradox of high interest rates under both a weak and strong currency scenario. I just wanted to briefly follow up (as the 144 character count limit for asking questions made it difficult to put my question in context). With respect to the second half of the question, my assertion that interest rates could/would rise in a strong currency scenario: this was based on the idea that the currency in question, being in high demand, would thus demand a greater price in the market. For non-monetary goods this would be seen in terms of falling prices (i.e. more goods to buy some fixed quantity of money), but it gets tricky when it comes to using money to buy money…so if someone had a bunch of money and I wanted to borrow it and they were unwilling to give it up because it was scarce (in high demand) then in order to incentivize them to shift their time preference for these funds in my direction I would be willing to pay them a high price, i.e. a greater interest rate.

In other words, in a scarce money stock scenario, where deflation is generally occurring for money with respect to non-monetary goods, it seems the cost of shifting ones time preference for that scarce good would also go up, so one is willing to pay more money at a future date… so in a sense would not a higher interest rate be deflationary as well, e.g. under low demand it costs $5 per $100 to get someone to lend it out, under high demand it costs $10 per $100 to get someone to lend it out, so formerly one $1 of interest income cost $20 in time preference shifting, now it only costs $10 in time preference shifting… the person with the money can “buy” more interest with his deflated, high demand currency.

So, am I still missing something here, or is it perhaps that both are true but it is not a paradox because it is two different things that are driving the interest rate. Under a depreciating (low demand) currency scenario the interest rate is driven by future value expectations – we _know_ it will be worth less in the future, so the interest rate is not so much a true interest rate as it is an interest rate (pure time preference) + a “make up for value lost so we get at least our principal back” rate.

But, under an appreciating (high demand) currency scenario the interest rate is primarily time preference driven and given a high demand asset, time preference goes up and thus it requires more of a monetary inducement (interest rate) to get one to shift their time preference.

Under an inflating currency the time preference itself is artificially shifted down because money is “easy” to come by… under a deflating currency the time preference is artificially shifted up because money is “hard” to come by… although I suppose in an unhampered market one could see the same effects and we would remove the descriptor “artificially”… so ceteris paribus, the harder money is to come by the higher the interest rate will be (i.e. if we could magically extract just the pure time preference rate under a high inflation scenario it would always be lower than the pure time preference rate under a deflation scenario).

So does any of this make sense or am I missing something big. Thank you for your time.
Greg

[jmherbener]

The 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.

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