Expansion of Credit On Interest Rates Clarification

Economics Economics Questions
1

I have just finished reading “An Introduction to Austrian Economics” by Thomas C. Taylor. Overall it was a great read for a beginner such as myself and highly recommend it to others just starting to learn about the Austrian school of thought.

My question is regarding a clarification of the following paragraph:

(Page 92)

“The expansion of credit, ie., the increase in the money supply, through the joint action of the federal government and the banking system tends to lower the interest rate below a level that would otherwise prevail in a market devoid of such actions to increase the money supply. In the early stages of the credit expansion the interest rate actually drops. Subsequently, as the effect of such policies on prices throughout the market becomes apparent, a price premium is added to the interest rate in order to protect the savers from the harmful impact of expected price increases. Note, however, that this price premium starts AFTER the price effects have occurred so that, in largely mirroring such effects, it must necessarily lag behind what would be adequate to cover further price increases under continuing inflation. Because of the price premium, the interest rate tends to rise over time despite continued additions to the money supply. Nevertheless, continued doses of additional money dampens this rise in the interest rate so that it continues to lag behind the height at which it would cover both ordinary interest plus the positive price premium.”

The portion I am having difficulty understanding is this: “a PRICE PREMIUM is added to the interest rate in order to protect the savers from the harmful impact of expected price increases”

I guess I am not quite understanding what force causes the interest rates to move upward after the money supply is increased. Any help is greatly appreciated.

2

Lets suppose you wish to deposit money somewhere. If you expect general rise of prices (decrease of money purchasing power), then you ask for higher interest (price premium). Otherwise you could even loose in real terms, your money would purchase less “after” than “now”. You just ask for compensation.

Central bankings always lowers real interest rate though nominal rate might skyrocket because of inflation. Try another book, it might be explained there much better.

3

Thanks for the response. I am sort of wanting to “double check” my thinking of how the interest rate reacts to an increase in the money supply.

Suppose we have an island community of 10 people, each with $100. So there is a total of $1000 on the island. Let us now say that the central bank on this island prints an additional $1000 and begins to slowly release it out to the members of the island.

Now, it is my understanding that when these dollars are at first let out to the community, it gives them a false signal of a larger pool of savings (as money appears now to be more abundant then before, ie. as if people had saved and deposited in the bank). This then causes the members of the island to perceive a lower interest rate then what it was before?

Now, sort of skipping ahead on this island scenario, let us say that the central bank eventually gives out all of the money and it gets evenly distributed throughout the island so that each of the 10 members has $200 (there was $1000 originally, plus the $1000 of printed money = $2000). So now we are at the same situation as at the start of the printing spree as all members of the island have the same purchasing power. Can one make the assumption then that the market interest rate will now be the exact same as it was before the credit expansion?

I guess what I am trying to make sure is correct logic is the following. At the start of the credit expansion let us say the market-determined interest rate is x% (based on the current balance of money used for savings, and consumption by the island members). Now once the credit expansion begins, the market-determined interest rate is still at x% (as the real resources that have been set aside for present consumption, and future consumption has not changed), however it is perceived by the public as if it is some interest rate below x%? Then as time plays itself out, the perceived interest rate will begin to rise again until it “matches” back up to the original market-determined interest rate of x%?

It seems to make sense that, assuming the members of the island don’t change their time preference for things, the market-determined interest rate should be the same value before the credit expansion as after (ie. everyone has the same amount of money before the expansion as after, in so far as relative to other members of the island). It also seems to make sense that the public will perceive a lower interest rate at the beginning of the expansion, as money now seems more easy to come by (because it has in fact been increased). What I am having trouble wrapping my head around is what are the exact forces that will cause the public to overtime change their perception of the interest rate so that it begins to rise again back up to the normal level? This is really the main point I am trying to better understand. I am assuming it has something to do with the public noticing the prices of things going up, and how they react to that, but I don’t quite have it figured out. If someone could please help explain to me this process, perhaps from a step-by-step point of view of a member on the island from the beginning of the credit expansion to the end, it would be much appreciated.

Please feel free to rip apart any incorrect notions I have. I have just begun to learn about Austrian economics and will definitely not be taking any corrections personally. I am just so eager to get a better understanding of this school of thought, and this forum seems like it is full of members with a wealth of information.

4

I look at it different way. In the beginning interest rate is determined mainly by pure interest (time preference), investment opportunities (returns on investments known to enterpreneurs) and risk factors. While pure interest rates and willingness to take risk constitute supply side, investment opportunities (expected yield and risk involved) constitute demand side. The result here is market interest rate. What is changed by inflation? Certainly investment opportunities are still the same, but pure interest rates and risk behavior are altered.

Central bank creates new money and lends them. It is mere robbery. While most of people face diminished purchasing power of their cash holdings, some are happy to get this stolen purchasing power in their pockets (first receivers on newly printed greenbacks). New money are loaned to existence, therefore they increase supply on financial markets. Ceteris paribus, increased supply must lower interest rate in real terms. (In nominal terms interest rates might be higher due to price premium we have discussed above.)

This should be an answer to your questions. Real interest rate is really lowered, it is no illusion! Resources were redistributed, they were added to supply of loanable funds, they had to lower interest rate. Only if central bank stops the inflation interest rate can get back to its original free market level.

From now on we shall leave the realm of standard Austrian analysis. Since interest rate is truly lowered in real terms, this process cannot cause business cycle more than usual government redistribution does. Enterpreneurs merely adjust their decisions to new redistribution scheme, nothing else. There is no malinvestment, no hidden mistake that might be revealed some day. Yet we can go further, we can look at the risk factor.

Commercial banks are in fact unable to create true money. Once on fractional reserves they produce some more or less perfect money substitutes. But they pretend to create money (so good is this disguise that many Austrians are misled too) though they produce mere promises to pay backed by some investments they have made. Fortunately for them central bank steps in as a lender of last resort. Depositors are led to believe in perfect “moneylikeness” of their demand deposits by promise of Fed (ECB and others) to print as much paper fiat money as necessary to bail any bank if necessary. This is crucial feature of modern banking systems, there are two completely different general means of payment, true cash money and mere deposits, promises to pay cash. Their exchange ratio is fixed artificially at level 1:1. Thus depositors are led to believe in zero risk level. On the contrary enterpreneurs can get very cheap loans even in case of very risky investments free market would not allow to materialise. There lies the problem, there is the cause of cluster of errors. It cannot be caused (as many Austrians believe) simply by inflation. Market participants would be perfectly able to adjust their decisions to this new reality. There must be double mistake, one group acting against another, one group misled by fables to believe in no risk at all while others are led to believe in huge risk to be allowed (at the same time).

End of inflation would cause immediate revelation of too risky investments. Most people would probably have to cut their consumption, to save much more. World would not be really the same as before the inflation, recovery would take some time.

5

The price premium is for inflation. When inflation starts to rise but rates are stagnant, individuals will begin to pull money out of banks, decreasing the supply of credit. This amplifies, as banks that practice fractional reserve banking need to reduce the loans they make by several times to keep their reserves somewhat sensible. At the other end, as inflation rises above price expectations, businesses that took out loans either fail - since they cannot pay for everything they need - or they need to take out more loans, increasing demand, and thus the price, for credit (or the interest rate, in other words). There are several other factors that contribute to this, but these are the two major ones.

However, if the monetary supply expands from outside the banking system, the inflation won’t have as big of an effect. For example, if gold is discovered or if the government deficit spends that money is spent and saved according to people’s preferences right off the bat, so it doesn’t create a “disequilibrium” like new credit injected into the banking system does.