According to mainstream thinking, the central bank is the key factor in determining interest rates.
By setting short-term interest rates, the central bank, it is argued, through expectations about the future course of its interest rate policy can influence the entire interest rate structure.
Thus according to the popular way of thinking, the long-term rate is an average of current and expected short-term interest rates. If today’s one year rate is 4% and next year’s one-year rate expected to be 5%, then the two-year rate today should be 4.5% (4+5)/2=4.5%.
Conversely, if today’s one year rate is 4% and next year’s one-year rate expected to be 3%, then the two-year rate today should be 3.5% (4+3)/2=3.5%.
Note that interest rates in this way of thinking are established by the central bank whilst individuals in all this have almost nothing to do and just form mechanically expectations about the future interest rate policy of the central Bank.
Individuals here are passively responding to the possible interest rate policy of the central bank. However, does it make much sense?
We suggest that the key in interest rates determination is people’s time preferences. What is it all about?
People assign higher valuation to present goods versus future goods
As a rule, people assign a higher valuation to present goods versus future goods. This means that present goods are valued at a premium to future goods.
This stems from the fact that a lender or an investor gives up some benefits at present. Hence, the essence of the phenomenon of interest is the cost that a lender or an investor endures.
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.
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