Interest Rates

Interest rates are the price of borrowed money,

but seen more deeply and from the perspective of the entrepreneur Opens in new window, are the price paid to gain access to the available savings for use in production.

There are two associated concepts that must be kept straight since both are crucial to understand the nature of investment Opens in new window and economic growth Opens in new window, the money rate of interest and the natural rate of interest. These are discussed in turn below.

Money Rate of Interest

The money rate of interest is the price of money and credit.

The money and credit received, usually from financial institutions, can be used to buy the resources needed for production, but are not themselves those resources.

Interest rates are determined by the supply and demand for such funds.

Interest rates are influenced by:
  • the risks associated with lending the funds to particular users,
  • the current rate of inflation,
  • the call on funds by governments,
  • and by any other factor that influences either the willingness to lend by those with funds or the willingness to borrow by those without.
That is, interest rates are determined by the supply and demand for money and credit.

Natural Rate of Interest

The natural rate of interest is the price of the real savings available in an economy Opens in new window.

Real savings is an aggregate concept which embodies all of the resources available for investment purposes.

While the supply of money and credit can be increased almost at will, increments to the amount of resources available can only take place very slowly.

In equilibrium Opens in new window, the money rate of interest and the natural rate are the same. If, however, they are different there are then a number of consequences for the economy.

Good economic policy will try to keep the two rates aligned by letting the market determine the money rate of interest.

Most importantly, if the money rate is lower than the natural rate, there are fewer resources available for use in investment project than there is money and credit.

The result is slower growth, misdirected resources and a higher price level. Artificially low money rates of interest can do great damage to an economy.