According to much popular economic thinking, there are three factors determining the market interest rates. The first is liquidity, the second factor is economic activity, and the third factor is inflationary expectations. Milton Friedman held that whenever the central bank raises the growth rate in money supply by buying financial assets such as Treasuries this pushes the prices of Treasuries higher and its yields lower. Note that what we have here is the monetary liquidity effect, which is inversely correlated with interest rates.

After a time lag, maintains Friedman, the increase in the money supply strengthens economic activity and this sets in motion the economic activity effect, which is exerting an upward pressure on the interest rates. After a much longer time lag, the increase in the growth rate of money supply begins to affect the prices of goods and services. Once prices start to move higher, inflation expectations are emerging. Consequently, this exerts a further upward pressure on the market interest rates.

Liquidity, economic activity, and inflation expectations are seen as the key factors in the determination of the interest rates. This process is set by the central bank’s monetary policies, which influences the monetary liquidity. The monetary liquidity in turn gives rise to the other two effects.

That said, this popular explanation of interest rate determination is derived from observations and not from a sound economic framework that interprets observations. In The Ultimate Foundation of Economic Science, Mises argued that,

What economic history, observation, or experience can tell us is facts like these: Over a definite period of the past the miner John in the coal mines of the X company in the village of Y earned p dollars for a working day of n hours. There is no way that would lead from the assemblage of such and similar data to any theory concerning the factors determining the height of wage rates.

What economic history, observation, or experience can tell us is facts like these: Over a definite period of the past the miner John in the coal mines of the X company in the village of Y earned p dollars for a working day of n hours. There is no way that would lead from the assemblage of such and similar data to any theory concerning the factors determining the height of wage rates.

Thus, such a........

© Eurasia Review