Interest Rates and Ratio Distortion

It is necessary for a lender of money to charge interest because the purchasing power of each money unit is generally expected to fall with time. This has been the trend historically and the very operation of the economy tends to make it so.

So, in order for the lender to show a profit in terms of purchasing power on the transaction they must charge interest equal to the rate of price increases (comprising inflation plus other influences) plus a profit margin.

Lenders, like everyone else, want an ever-rising living standard, so the interest rate they charge must be sufficient to show a purchasing power profit.

However this consideration must be balanced with the need to attract borrowers. If the interest rate is so high, that the purchasing power a borrower has to lose in interest charges is expected to be greater than the purchasing power they will gain in the end by borrowing the money, then they won’t borrow.

So interest rates appear to be determined by the tussle between lenders and borrowers for the best purchasing power advantage. But there are three points to note.

(i) Interest rates must be regulated to some degree, otherwise too much rapid unpredictable movement and large variations would create too much uncertainty.

(ii) A borrower often needs money for a particular purpose which cannot be postponed or abandoned. In this situation they must borrow money at a particular time even if the interest rate is so high that they expect a net loss of purchasing power in the longer term.

(iii) An important determinant of interest rates is the supply-demand one; the relation between the supply of money available for lending and the demand for loans from government, business, and consumers.

Upward pressure on interest rates results if demand exceeds supply, and downward pressure if supply exceeds demand.

For a couple of decades after 1970, in the more perfluent nations, demand for loans increased faster than the supply of loanable funds. This put upward pressure on interest rates.

Wealth depletion caused value inflation (see posting “Value Inflation – the Trigger, Not the Bullet”) to appear as a component of price increases. Because of the pressure of high and rising expectations taking no account of resource limits, this value inflation has triggered further price increases.

Wealth depletion also puts downward pressure on net throughput, not necessarily reducing it, but causing it to rise more slowly than expected.

Ratio distortion in the direction of wages developed and an excessive rate of price increases became chronic, with occasional remission.

The combination of a high price increase rate with the upward pressure resulting from supply-demand forces produced chronically high interest rates which are a reliable symptom of ratio distortion in the wage direction.

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