I've been thinking about price deflation and interest rates and I think there is a potential problem that I would like your thoughts on.
Note: I am referring to interest rates as the discount of future goods over present goods.
Note: I am referring to price deflation as the drop in the future price of goods.
I do not see a problem if prices are dropping by 2% while current goods have a 5% premium because a 3% interest rate handles this.
However, I do see a problem if price deflation is 4% while current goods have a 2% premium because the interest rate to handle this would need to be -2% and people would likely hoard their wealth before they loan it at a negative interest rate.
This seems like a problem to me because the market economy would want there to be savers and borrowers but the increase in the purchasing power of money is not allowing there to be loans because you can't charge a negative interest rate.
Im a newbie, but I think the answer is that the interest rate is not the discount of future goods over present goods, as you define it, but rather how much people want to be paid to give someone else the use of their money. Meaning the discount of future use of money compared over present use of money.
Even if that definition is wrong, the real world solution would be very simple. If someone really needed to borrow money for some reason, he would just have to pony up a higher interest rate to coax people to open their wallets and lend it.
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energybackedmoney: However, I do see a problem if price deflation is 4% while current goods have a 2% premium because the interest rate to handle this would need to be -2% and people would likely hoard their wealth before they loan it at a negative interest rate. This seems like a problem to me because the market economy would want there to be savers and borrowers but the increase in the purchasing power of money is not allowing there to be loans because you can't charge a negative interest rate.
You're using fisher's distinction between the so-called 'real rate of interest' and his 'nominal rate of interest' (i=r+pie). There is no one-to-one relationship between the interest rate and prices. Prices fall because there's an increase in the demand for cash holdings, or because output is increasing. Interest rates, at the natural rate, portray time preferences, while the market rate of interest may or may not.
"If we wish to preserve a free society, it is essential that we recognize that the desirability of a particular object is not sufficient justification for the use of coercion."
Smiling Dave:Im a newbie, but I think the answer is that the interest rate is not the discount of future goods over present goods, as you define it, but rather how much people want to be paid to give someone else the use of their money. Meaning the discount of future use of money compared over present use of money. Even if that definition is wrong, the real world solution would be very simple. If someone really needed to borrow money for some reason, he would just have to pony up a higher interest rate to coax people to open their wallets and lend it.
I got my present and future goods approach from Mises in Human Action: "The rate of originary interest is determined by the discount of future goods as against present goods. It is essentially independent of the supply of money and money-substitutes, notwithstanding the fact that changes in the supply of money and money substitutes can indirectly affect its height." - http://mises.org/humanaction/chap20sec6.asp
The problem I am trying to point out is that people won't "pony up a higher interest rate to coax people to open their wallets and lend it" because the "discount of future goods as against present goods" created by price deflation may already be too much of a discount. This can result in a situation where the market economy wants there to be lenders and borrowers, but the monetary system with price deflation does not allow the market forces to work.
Esuric:You're using fisher's distinction between the so-called 'real rate of interest' and his 'nominal rate of interest' (i=r+pie). There is no one-to-one relationship between the interest rate and prices. Prices fall because there's an increase in the demand for cash holdings, or because output is increasing. Interest rates, at the natural rate, portray time preferences, while the market rate of interest may or may not.
I agree there is no one-to-one relationship between falling prices and time preferences and that is why I think a problem can arise. As an extreme example, would anybody loan money in an environment where prices were dropping 10% per year when the discount on future goods against present goods was only 5%? In this example it seems like market forces want people to loan money and reallocate resources but nobody will because the purchasing power of money is growing too rapidly.
If I understand you correctly, you are saying that deflation will cause the guy with money to demand such a high interest rate that the guy who needs the money won't find it worth his while to borrow the money. OK so be it. That itself is the market at work. The deflation didn't drop down from Mars, nor did any of the other factors you mentioned. They are all market forces doing their thing.
Everybody wants everything. I want twenty yachts, for example. But I don't want them badly enough to pay for them. I want a job too. But if I'm offered ten cents an hour and the the cost of driving there and back is more than what I'm going to get in wages, then I don't want that job. So too the guy who wants money but isn't willing to pay the high rate, or won't turn a profit if he borrows at that high rate, well then he doesn't want the money, does he?
What will happen then? If new stuff isn't being made then people will just use up the old stuff till the demand for things increases, lowering the price of money, and interest rates will drop.
Smiling Dave: If I understand you correctly, you are saying that deflation will cause the guy with money to demand such a high interest rate that the guy who needs the money won't find it worth his while to borrow the money. OK so be it. That itself is the market at work. The deflation didn't drop down from Mars, nor did any of the other factors you mentioned. They are all market forces doing their thing.
Thanks for replying. Yes you understand me, but just to be clear I am saying that even a 0% nominal interest rate could effectively be such a large real interest rate that nobody would find it worth their while to borrow money. I agree that eventually the market forces would resolve this, but I guess my point is that this deflationary barrier to borrow money could result in an inefficient non-allocation of resources. I say "inefficient" because this barrier to borrow money might be caused by the monetary system put in place and not necessarily by market forces.
I thought of an example to help me make my point.
Imagine there were an apple entrepreneur was could turn 100 apples into 105 apples in one year.
If the purchasing power of money did not change and the nominal interest rate was 4% then the apple entrepreneur would have incentive to borrow money and could make a profit turning 100 apples into 105 apples.
If the purchasing power of money increased by 4% per year and the nominal interest rate were 3% then our apple entrepreneur would not be able to make a profit and would not borrow any money. However, this wouldn't be a problem because the interest rate suggests that some other entrepreneur is more efficient and is able to make a profit with these conditions.
However, if the purchasing power of money increased by 5% per year then there is no way our apple entrepreneur can turn a profit and therefore will not borrow money even at a nominal interest rate of 0%. Our apple entrepreneur may be the most efficient producer on the planet, but yet there will be nobody to loan them money and therefore no allocation of resources to the most efficient producer. Instead money is hoarded, resources sit idle, and 100 apples are not turned onto 105 apples.
energybackedmoney: However, if the purchasing power of money increased by 5% per year then there is no way our apple entrepreneur can turn a profit and therefore will not borrow money even at a nominal interest rate of 0%. Our apple entrepreneur may be the most efficient producer on the planet, but yet there will be nobody to loan them money because people have better uses for it and therefore no allocation of resources to the most efficient producer. of apples. but that means people dont want apples that much, if they arent willing to pay a higher price for them than what it costs him to make more. say a hoolah hoop maker knows how to make 105 hoops from the factory that used to turn out 100. and he's the only one on the planet that can do that. well too bad, nobody wants those extra 5 hoops Instead money is hoarded, You make it sound like something bad. Hey it's their money, they can do what they think is best. saving for a rainy day , or for when prices drop, is a perfectly legitimate use of money resources sit idle, the north pole is an idle resource, so is the moon, and mars too for that matter. what Im trying to say is that there is only so much money and human energy in this world. some resources are always gonna be idle.look at the city of cleveland frinstance. miles and miles of housing in ruins, waiting to be developed. but nobody wants to live there, so it lies idle. and 100 apples are not turned onto 105 apples. because people are happy with 100 apples for now
However, if the purchasing power of money increased by 5% per year then there is no way our apple entrepreneur can turn a profit and therefore will not borrow money even at a nominal interest rate of 0%. Our apple entrepreneur may be the most efficient producer on the planet, but yet there will be nobody to loan them money
because people have better uses for it
and therefore no allocation of resources to the most efficient producer.
of apples. but that means people dont want apples that much, if they arent willing to pay a higher price for them than what it costs him to make more. say a hoolah hoop maker knows how to make 105 hoops from the factory that used to turn out 100. and he's the only one on the planet that can do that. well too bad, nobody wants those extra 5 hoops
Instead money is hoarded,
You make it sound like something bad. Hey it's their money, they can do what they think is best. saving for a rainy day , or for when prices drop, is a perfectly legitimate use of money
resources sit idle,
the north pole is an idle resource, so is the moon, and mars too for that matter. what Im trying to say is that there is only so much money and human energy in this world. some resources are always gonna be idle.look at the city of cleveland frinstance. miles and miles of housing in ruins, waiting to be developed. but nobody wants to live there, so it lies idle.
and 100 apples are not turned onto 105 apples.
because people are happy with 100 apples for now
Smiling Dave:saving for a rainy day , or for when prices drop, is a perfectly legitimate use of money
I agree with the words you say, but it doesn't refute the point I am trying to make. I am saying it would be unfortunate if a monetary system brought on a deflationary lending barrier that would make putting your money in your mattress a better option than loaning it to the most effective entrepreneur who is willing to pay the highest real interest rate of anybody in any industry who could use the loan to turn 100 of something of value into 105 things each of equivalent.
Smiling Dave:the north pole is an idle resource, so is the moon, and mars too for that matter.
I agree with what you are saying but it doesn't refute the point I am trying to make. The North Pole, the moon, and mars should sit idle because people can get a better return on their investment elsewhere. However, the example I am trying to describe illustrates a scenario where resources offering the best rate of return of any resources would sit idle. In the last example, the apple entrepreneur wants to pay the highest real interest rate of anybody in any industry and yet nobody wants to loan them any money because they are better off putting their money in their mattress.
Smiling Dave:because people are happy with 100 apples for now
I was assuming people would prefer 101 apples to 100 apples. Maybe my points would be clearer if the apple entrepreneur was a gold mining entrepreneur and instead of apples it was ounces of gold. Can you see the tragedy of a deflationary monetary system that encouraged people to put dollars into mattresses instead of loaning it to the gold miner, the one who can turn 100 ounces of gold to turn into 105 ounces of gold, and the one who would pay the highest real interest rate of anybody in any industry?