Time Preference, Interest Rates, And Stagflation

Stagflation

A common conception is that the central bank is a key factor in the determination of interest rates. In this way of thinking, the key role of the central bank is to make sure that the so-called economy is placed on a trajectory of stable economic growth and stable inflation. If for whatever reason the economy appears to deviate from the specified trajectory, then it is the responsibility of central bank policy to ensure the economy remains on this path. This is attained, so it is held, by means of influencing the short-term interest rate, in the US the federal funds rate.

The central bank influences the short-term interest rates by influencing monetary liquidity in the markets. While asset buying by the US Fed raises the money supply, its selling of assets produces the opposite effect. Thus, by buying assets the Fed adds to the monetary liquidity, thereby lowering rates, while by selling assets the exact opposite is taking place.

Popular thinking also suggest that long-term rates are the average of current and expected short-term interest rates. If today’s one year rate is 4 percent and the next year’s one-year rate is expected to be 5 percent, then the two-year rate today should be 4.5 percent ((4+5)/2=4.5 percent). Conversely, if today’s one-year rate is 4 percent and the next year’s one-year rate is expected to be 3 percent, then the two-year rate today should be 3.5 percent (4+3)/2=3.5 percent.

Time Preference and Interest Rates

It is individuals’ time preferences rather than the central bank, however, that are the key to the interest rate determination process. What is it all about?

An individual who has just enough resources to keep himself alive is unlikely to lend or invest his paltry means. The cost of lending, or investing, to him is likely to be very high—it might even cost to lend part of his means. Therefore, he is unlikely to lend or invest even if offered a very high interest rate.

Once his wealth starts to expand, the cost of lending, or investing, starts to diminish. Allocating some of his wealth toward lending or investment is now going to undermine his life and well-being to a lesser extent. On this Mises wrote,

That which is abandoned is called the price paid for the attainment of the end sought. The value of the price paid is called cost. Costs are equal to the value attached to the satisfaction which one must forego in order to attain the end aimed at.1

According to Carl Menger:

To the extent that the maintenance of our lives depends on the satisfaction of our needs, guaranteeing the satisfaction of earlier needs must necessarily precede attention to later ones. And even where not our lives but merely our continuing well-being (above all our health) is dependent on command of a quantity of goods, the attainment of well-being in a nearer period is, as a rule, a prerequisite of well-being in a later period….All experience teaches that a present enjoyment or one in the near future usually appears more important to men than one of equal intensity at a more remote time in the future.2

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