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Basic: Why would interest rates go up when people save less in a free market economy? (In a

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posted on Tue, Nov 27 2012 12:46 PM

Hello to everyone! It's my first post here, and I'm glad this forum exists. 

I'm familiar to Austrian Economics for some time and have read several "Austrian" books. Today, all of a sudden, the following thought crossed my mind: Why is it, actually, that in a free market economy interest rates would go up when people save less? Until today, it seemed obvious to me: Less savings means less to lend out for the banks (supply of savings goes down, price goes up). But now something bothers me: When people trade with each other, the money simply goes from one bank account to the other. So the amount of available money seems to stay the same for the banks...

I tried to solve this puzzle by thinking: When people save more, prices fall and the value of their money rises. That could be the same as if there were just more money. But that thought doesn't help, because the amount of money still stays the same, so interest rates are nominally the same as well... 

I would be very glad if someone could help me with this. It's sure some sort of fallacy of mine, but yeah... Thank you in advance. 

 

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Clayton:

I think that's a bit glib. Money substitutes - hell, banking itself - only work if there is some kind of securitization of the assets held.

The Hawala system, from the wiki info, looks a lot like what I described in terms of Ft. Knox gold exchanges. It's all pooled together.

That system also looks a bit like how bitcoin payment obscurers work, or perhaps could work.

Clayton:
It doesn't have to be government doing it (in fact, one could argue that the breakdown of the global financial system is naught else but the result of governments securitizing financial instruments) but, somehow, there has to be securitization. Look at Hawala to see a system of distributed securitization.

The question is where does trust enter the system, and what is the basis of that trust. Under Hawala, it's reputation of the two money-holders. Under fiat money it's legal enforcement. Under commodity's its demand for that commodity which is expected to remain fairly stable (though it's perfectly possible in theory for a commodity's value to collapse just like any other price, should demand disappear for any reason). Under bitcoin, it's the strength of crypto underlying it.

So, take your choice.

 
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Leon Wolf:
Great analogy, thank you! One last question: What about an economy where everything is like in the US except for the FED leaving the interest rates alone? Would interest rates still go up if people saved less and go down if people  saved more?

Without the Fed fixing interest rates, or any other similar government interventions in the credit markets, then rates would be set by supply and demand for loanable funds, as we've been discussing. Assuming demand remains the same, then, yes, more savings means lower rates, less savings means higher rates.

Even though there's online banking, for example, so the money changes bank accounts extremely quickly and is thus almost always available for the banks?

I don't think the speed with which the money moves is a factor here. Returning to the analogy, it doesn't matter how fast the water moves along the circuit of the waterslide, if the waterslide gets longer, so that more water is in it at any one time (as opposed to being in the pool), then the volume in the pool shrinks. The water can be flowing at 1 mph or the speed of light, doesn't matter, there's still less in the pool.

By the way: Would online banking exist under a gold standard?

It could, and I assume it probably would. In a free market banking situation, paper money could still exist (and almost certainly would), but it would be redeemable for gold. Electronic money could be similarly redeemable. If you have $100 in your online account, you can go down to the bank and get cash, right? Well, then you could go down to the bank and get gold (or get cash which is redeemable for gold).

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replied on Thu, Nov 29 2012 9:15 AM

I don't think the speed with which the money moves is a factor here.

Actually, I don't think so either, and of course, also in your analogy, the speed doesn't matter as soon as the water cycle is closed. Still, if we go away from that analogy, I can't understand it yet. Because, as already written: Assume, all people save, meaning all people have their money in their bank accounts. That's the money available for the banks. The banks have all the people's money available for lending out (I know, in our fractional reserve banking system, the banks create money out of thin air and don't just take the money from the one and lend it out to the other, but let's fade that out for now). Now when people become more spendthrift and much money goes from one person's account to the other, in my understanding, then the amount available for the banks doesn't change, except for during the exchanges - however, when it comes to online banking and it takes, say, one second for each transaction, then this time in which the banks don't have the money available almost vanishes and it shouldn't matter - I know, it sounds strange - whether people save or consume more or less. As I see it, three things influence the supply of loanable funds to the banks: The duration of the transactions, the size of the transactions and the number of the transactions...

This seems so extremely basic that it bugs me, for I thought I understood it and now realize I've never really thought it through.

 

By the way, @ Anenome, Clayton and some others: Don't think I ignore you, I find it interesting to read what you write, and it seems logical to me. It just interests me the most to understand why the banks have less loanable funds available if people spend more and save less. 

 

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But there's money which is entirely outside the banking system (physical paper notes and coins) and the quantity of this money varies. If people are spending more and saving less, money moves out of the banking system altogether (not just from one bank to another) and into circulating cash. Eventually, this cash will make it back to some bank, yes, but in the meantime, it's out there, not in the bank, meaning the bank has less to loan out.

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replied on Fri, Nov 30 2012 8:04 AM

Of course, but that would still mean when all transactions were made through online banking, it practically wouldn't matter how much people save or spend, at least the interest rates would be unchanged... which I somehow cannot believe.

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