The Essence of Interest Rate Determination
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 influences the entire interest rate structure. (According to the expectations theory (ET) the long-term rate is an average of the current and expected short-term interest rates). Note that interest rates in this way of thinking is set by the Central Bank whilst individuals in all this have almost nothing to do and just form mechanically expectations about the future policy of the Central Bank. (Individuals here are passively responding to the possible policy of the Central Bank).
Following the writings of Carl Menger and Ludwig von Mises we suggest that the driving force of interest rate determination is individual’s time preferences and not the Central Bank.
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.[1]
For instance, an individual who has just enough resources to keep him 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 him his life if he were to consider lending part of his means. So under this condition he is unlikely to lend, or invest even if offered a very high interest rate.
– See more at: http://www.cobdencentre.org/2015/09/the-essence-of-interest-rate-determination/#sthash.zySUavSN.dpuf
