I got some insight into this question from reading America’s Great Depression [available free at mises.org].
We are going to talk, yet again, about liquidity theory versus time preference theory. A search of this humble blog will reveal a few earlier articles we have written on the subject. This time, armed with new insight, we will lay it all out, Smiling Dave style.
All economists agree that when a man takes home his newly earned money, he can do three possible things with it.
1. He can just leave it in his wallet. This is called “hoarding” if you think it’s a bad thing, as Keynes did, or “increasing ones cash balances” or “increasing ones demand for money” if you think it’s OK.
2. He can spend it on things he wants to consume.
3. He can try and use the money to make more money. This is called investing his money.
Obviously, he need not put all his eggs in one basket. He can use part of his money to invest, part of it to consume, and part of it he can just keep in his wallet for now.
OK, where do interest rates fit into all this? Very simple. What if you, dear reader, have money sitting in your wallet, and I want to open a shoe store, and need your money to help me get started. How do I convince you to part with your hard earned money and lend it to me? The obvious method is to promise to pay you interest. If you agree, you have changed what you do with your money from hoarding to investing.
How much interest should I offer you? Keynes said, “Whatever it takes. Mr. Dear Reader obviously wants to keep his money in his wallet for now, and your job is get him to change his mind. You have to overcome his ‘liquidity preference’, meaning his desire to just keep it right there in his wallet, unspent and uninvested, by making it worth his while, in his opinion, to give it to you.”
And whatever it takes to convince the dear reader to lend me his money is what the interest rate is going to be. This is the liquidity preference theory of the interest rate.
Mises has said about the liquidity preference theory of interest that it is
…a view, indeed, of insurpassable naivete. Scientific
critics have been perfectly justified in treating it with con-
tempt; it is scarcely worth even cursory mention.
Which raises an obvious question, to wit, why does this theory deserve to be treated with contempt?
I can think of one reason. First of all, I will not pay you whatever it takes. There is a certain amount of profit I can expect to make if I open my shoe store, [say 10%] and I cannot possibly offer you more than that, obviously. Second of all, what will make you happy is also determined by how much the shoe store can make. If, after reading through my business plan, you see I expect 10% profits before repaying you, you will not be content with the same interest rate as would be the case if my forecasts were that I will make 2% profits, or [on the other hand] 50% profits.
Thus, both from my side of things and from your side, the interest rate depends on how much profit is to be made from my shoe store.
Which leads right in to the Austrian theory of interest rates, that indeed the profits to be made from the shoe store [called the “natural rate”] will determine what the interest rate will be on loans.
Then the question arises, what determines how much profit the shoe store will make? This leads us to deep territory. Which is beyond my abilities for now. Luckily, we have mises.org to help us out with this, so I place you in their gentle hands.