What makes interest rates move up and down? That’s not a question for your Econ 101 final exam. It’s a real-life issue that impacts the price you pay for credit — for a mortgage, a student loan, a credit-card balance, or a car loan. And these days, you’ll get a lot of disagreement about where interest rates are headed, and why.
Interest is the price of money. The interest rate is the price a borrower pays to get money. A few basic things affect the price of anything in a free market: the availability of the commodity (money, in this case) and the credit-worthiness of the borrower (i.e., you wouldn’t lend money to a deadbeat without exacting a very high price, a very high rate of interest).
Now, in a truly free market, the price of any commodity is impacted by supply and demand. Take corn, for example. Every year, the farmers around the world plant a new crop of corn. (Corn is a global commodity, though dominated by the United States, which exports 20 percent of its crop.) The price of corn depends on how many acres are planted, and how the weather impacts the growing season. By harvest time in the fall, the markets have analyzed the size of the crop; and the world’s corn users (ranging from corn flakes manufacturers to ethanol producers to animal and poultry feeders) determine how much they need to buy. Then the price is set in the futures markets, where buyers and sellers meet.
The price of money is similarly set by global markets. In the global marketplace for money, the price is influenced by governments and central banks, which determine the amount of the money crop that will be created and the price of the money crop: interest rates.
Let’s start with our domestic “crop” of money. Yes, the government helps create the annual supply of money through its power to borrow money by selling government IOUs — Treasury bills, notes, and bonds — adding to the stock of existing bonds it sold to borrow money in previous years.
When the Fed — our central bank — buys those bonds in the open market, it pays for them with newly created credit (money), which goes into the system, adding to the money supply. In recent years, the Fed has created literally trillions of dollars in “new money” to help the government borrow to finance its deficits. If there’s plenty of money crop available, then interest rates can remain low — at least for a while.
But unlike commodities such as corn and copper, a greater supply of money does not necessarily make its price go down. That’s because — eventually — people will look at this huge supply of paper and wonder what it is really worth in buying power, if the government keeps creating more of it.
Think of Zimbabwe in recent years, where a $1 billion paper bank note bought only a loaf of bread! The technical name for this kind of destruction of confidence in the paper currency is inflation. Despite all the money created in the United States in recent years by the Fed, we don’t have any signs of inflation, yet. The U.S. dollar is still in great demand around the world.
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This post originally appeared on Western Journalism – Informing And Equipping Americans Who Love Freedom