No, the interest rate is not the price of money

The notion that the interest rate is the price of money is seriously misled. As I move forward with my lectures on the Keynesian system, this is something that I want to make clear to my students. Certainly, when evaluating the Keynesian model, we need to understand what the model says (and what it does not say), but unfortunately, textbooks do not always tackle controversial issues. This is an example of the perpetuation of errors and misconceptions by textbooks. To see this for yourself, simply open a random macroeconomics textbook and read what it has to say about the classical economists– then, open a book actually written by a classical economist and compare what the two have to say.

It should be clear that the interest rate is not the price of money. For starters, if you get money and pay interest, eventually the day will come when you have to return the amount of money (plus interest.) If you have to return it, then you didn’t buy the money and so the interest rate is not the price of buying money.

But more significantly, a few scenarios that have to do with interest rates but not money come to mind. Let’s say that I lend you 10 apples on condition that you will return 11 apples to me one year from now. There is a 10 percent interest rate, but no money involved. If we are not ready to say that the interest rate is the price of apples, then for the same reason we should not be ready to say that the interest rate is the price of money. The other characteristic that this example illustrates is that the interest rate is not a monetary phenomenon. It is, in fact, a time phenomenon. The interest rate is the price of time, or credit, but not the good in which the credit takes place. Certainly, it is easier for individuals to take out loans in money than in apples. In the latter case, you have to sell the apples, get the money, do your business and then buy the apples with interest and return them to me. But the fact that it is easier to make loan transactions in the form of money does not make interest rates the price of money. In other words, (subjective) time preference is to interest rates what (subjective) marginal utility is to prices.

Why, then, such confusion about interest being the price of money in the Keynesian system? Really, it’s because of how the model is constructed. In the Keynesian system, wealth is divided only into two types of assets: (1) money and (2) bonds. Then, an increase in the demand for money (assume that wealth is constant) means that the individual or firm sells bonds to get more cash in his portfolio. All else equal, the price of the bond falls and therefore the interest rate increases. Higher demand for money means higher interest rates. This is the relationship we should expect between a good and its price. But the bond also has a market price, which fell. If the price to buy a bond is P, then the price of money in terms of bonds is 1/P. Yes, the way the Keynesian system is built leads one to think of the interest rate as the price of money, but there is no need to fall in this trap.

The difficulty with the price of money is that money is the unit of account, and its price does not come in a clear unit of account, but rather in how many goods (from a defined basket) need to be sold to buy one dollar. The inverse to the operation of buying goods by selling money is to buy money by selling goods. Then, the price of the good in terms of money (p) and the price of money in term of goods (1/p) are the inverse of each other.

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