WEBVTT NOTE 6.11. The Time Structure of Interest Rates 1 00:00:00.000 --> 00:00:02.000 11. 2 00:00:02.000 --> 00:00:05.560 The Time Structure of Interest Rates 3 00:00:05.560 --> 00:00:09.960 It is clear that the natural interest rates are highly flexible. 4 00:00:09.960 --> 00:00:17.280 They tend toward uniformity and are easily changed as entrepreneurial expectations change. 5 00:00:17.280 --> 00:00:22.840 In the real world, the prices of the various factors and intermediate products, as well 6 00:00:22.840 --> 00:00:29.980 as of the final products, are subject to continual fluctuation, as are the prices of stock and 7 00:00:29.980 --> 00:00:32.180 and the interest return on them. 8 00:00:32.180 --> 00:00:38.380 It is also clear that the interest rate on short-term loans is easily changed with changed 9 00:00:38.380 --> 00:00:39.640 conditions. 10 00:00:39.640 --> 00:00:45.940 As the natural interest rate changes, the new loans for short periods can easily conform 11 00:00:45.940 --> 00:00:48.140 to the change. 12 00:00:48.140 --> 00:00:54.820 A difficulty seems to arise, however, in the case of long-term producer's loans. 13 00:00:54.820 --> 00:01:01.580 Here is an apparently clear-cut rigid element in the system, and one which can conform to 14 00:01:01.580 --> 00:01:07.420 the natural rate of interest in investments only after a great lag. 15 00:01:07.420 --> 00:01:13.880 After all, a 20-year loan is contracted at an original interest rate that remains fixed 16 00:01:13.880 --> 00:01:15.740 for the duration. 17 00:01:15.740 --> 00:01:22.640 Is this not a fixed element that cannot conform to changing conditions and valuations? 18 00:01:22.640 --> 00:01:30.920 This superficial view is incorrect. Long-term IOUs can also be bought and sold in a market. 19 00:01:30.920 --> 00:01:37.220 Most of these long-term debts are called bonds, and they are traded in a flourishing and flexible 20 00:01:37.220 --> 00:01:44.720 bond market. The fixed rate of interest at the beginning is unimportant. Thus, a 100-ounce 21 00:01:44.720 --> 00:01:52.520 Its long-term loan is contracted at 5% fixed interest, or 5 ounces per year. 22 00:01:52.520 --> 00:01:57.980 If the general interest rate rises, people will tend to sell their bonds, which have 23 00:01:57.980 --> 00:02:05.240 been yielding them only 5%, and invest their money elsewhere, either in whole firms, stocks 24 00:02:05.240 --> 00:02:08.240 of firms, or short-term loans. 25 00:02:08.240 --> 00:02:15.180 This increased willingness to sell bonds, an increased supply schedule, depresses the price 26 00:02:15.180 --> 00:02:21.820 of the bond, until the interest yield to the buyer is the same as the general interest 27 00:02:21.820 --> 00:02:22.820 rate elsewhere. 28 00:02:22.820 --> 00:02:30.560 Thus, if the general interest rate goes up from 5% to 10%, the price of the bond will 29 00:02:30.560 --> 00:02:38.280 will fall from 100 to 50, so that the fixed annual return of 5 will provide an interest 30 00:02:38.280 --> 00:02:40.760 yield of 10%. 31 00:02:40.760 --> 00:02:46.400 The important element in bond investment is not the original interest rate, the fixed 32 00:02:46.400 --> 00:02:53.920 return on the so-called par value of the bond, but the interest yield on the market price 33 00:02:53.920 --> 00:02:55.320 of the bond. 34 00:02:55.320 --> 00:03:01.880 A general lowering of the interest rate will, on the other hand, raise the bond prices above 35 00:03:01.880 --> 00:03:06.240 par, and push yield below 5%. 36 00:03:06.240 --> 00:03:11.720 As the day of redemption of the bond draws near, the market price of the bond will, of 37 00:03:11.720 --> 00:03:18.920 course, rapidly approach the par value, until it finally sells at par, since the amount 38 00:03:18.920 --> 00:03:25.480 The theory of money is based on the principle of the loan. 39 00:03:25.480 --> 00:03:32.400 It is clear that in the ERE the interest rates for all periods of time will be equal. 40 00:03:32.400 --> 00:03:38.840 The tendency toward such equality at any one time, however, has been disputed in the case 41 00:03:38.840 --> 00:03:43.240 of expected future changes in the interest rate. 42 00:03:43.240 --> 00:03:48.460 Although surprisingly little attention has been devoted to this subject, the prevailing 43 00:03:48.460 --> 00:03:55.200 theory is that on the loan market there will not be a tendency toward equalization if a 44 00:03:55.200 --> 00:04:00.080 change in interest rates is expected in the near future. 45 00:04:00.080 --> 00:04:05.760 Suppose that the interest rate is now 5% and it is expected to remain there. 46 00:04:05.760 --> 00:04:12.720 Then the interest rate on loans of all maturities will be the same, 5%. 47 00:04:12.720 --> 00:04:25.720 It is, however, that the interest rate is expected to increase steadily in the near future, say, to increase each year by 1% until it will be 9% four years from now. 48 00:04:25.720 --> 00:04:37.720 In that case, since the short-run rate, say, the rate of interest on loans lasting one year or less, is expected to increase over the next four-year period, 49 00:04:37.720 --> 00:04:45.120 And the present long-run rate for that period, for example, the present rate for 5-year loans, 50 00:04:45.120 --> 00:04:50.880 will be an average of the expected future short-run rates during this period. 51 00:04:50.880 --> 00:05:02.340 Thus, the present rate on 5-year loans will be 5% plus 6% plus 7% plus 8% plus 9% divided 52 00:05:02.340 --> 00:05:06.040 by 5, equaling 7%. 53 00:05:06.040 --> 00:05:12.080 The long-run rate will be the average of short-run rates over the relevant period. 54 00:05:12.080 --> 00:05:18.600 Consequently, the long-run rates will be proportionately higher than short-run rates when the latter 55 00:05:18.600 --> 00:05:25.840 are expected to increase, and lower when the latter are expected to be lower. 56 00:05:25.840 --> 00:05:30.200 This however is a completely question-begging theory. 57 00:05:30.200 --> 00:05:33.480 Suppose that a rise in interest rates is expected. 58 00:05:33.480 --> 00:05:38.440 Why should this be simply confined to a rise in the short-term rates? 59 00:05:38.440 --> 00:05:46.400 Why should not the expectation be equally applicable to long-term rates so that they rise as well? 60 00:05:46.400 --> 00:05:52.840 The theory rests on the quite untenable assumption that it sets out to prove, namely that there 61 00:05:52.840 --> 00:05:58.720 is no tendency for short-term and long-term rates to be equal. 62 00:05:58.720 --> 00:06:04.840 The assumption that a change in the interest rate will take place only over the short term 63 00:06:04.840 --> 00:06:11.360 is completely unproved, and goes against our demonstration that the short-run and long-run 64 00:06:11.360 --> 00:06:14.160 rates tend to move together. 65 00:06:14.160 --> 00:06:19.840 Further, the theory rests on the implicit assumption that individuals will be content 66 00:06:19.840 --> 00:06:27.400 to remain lenders in shorts at 5 percent, while their fellow investors reap 7 percent 67 00:06:27.400 --> 00:06:33.500 on the long market, simply because they expect that eventually, if they stay in the short 68 00:06:33.500 --> 00:06:37.800 market, they will earn an average of 7%. 69 00:06:37.800 --> 00:06:44.240 What is there to prevent a present lender in shorts from selling his currently earning 70 00:06:44.240 --> 00:06:53.820 5% loan, purchasing a 7% long, waiting for the presumed rise in shorts above 7% after 71 00:06:53.820 --> 00:06:55.820 The Theory of Money and Credit 72 00:07:23.820 --> 00:07:33.460 By striving to do so, he will set up an irresistible arbitrage movement from shorts to longs, with 73 00:07:33.460 --> 00:07:39.900 the rate of interest in the former thereby rising from the sales of loans on the market, 74 00:07:39.900 --> 00:07:46.520 and the rate of interest in longs falling, until the rate of interest is uniform throughout 75 00:07:46.520 --> 00:07:49.200 the time structure. 76 00:07:49.200 --> 00:07:55.080 The same thing occurs in the case of an expectation of a future fall. 77 00:07:55.080 --> 00:08:01.360 Longs cannot remain in equilibrium below shorts for any length of time, since there will be 78 00:08:01.360 --> 00:08:07.540 a present movement from longs to shorts on the market, until the rates of interest for 79 00:08:07.540 --> 00:08:13.640 all time structures are equal, and the arbitrage movement ceases. 80 00:08:13.640 --> 00:08:20.240 The interest rate, then, always tends to be uniform throughout its time structure. 81 00:08:20.240 --> 00:08:25.100 What happens if the interest rate is expected to change in the near future? 82 00:08:25.100 --> 00:08:32.480 In that case, there will be a similar process, as in the case of speculation in commodities. 83 00:08:32.480 --> 00:08:38.040 Speculators will bid up the interest rate in the expectation of an imminent rise, or 84 00:08:38.040 --> 00:08:41.880 bid down the rate in expectation of a fall. 85 00:08:41.880 --> 00:08:48.620 Clearly, the earlier a rise or fall is expected to take place, the greater proportionately 86 00:08:48.620 --> 00:08:54.440 will be the effect on the speculators, and the greater impact it will have on current 87 00:08:54.440 --> 00:08:56.540 movement in the rate. 88 00:08:56.540 --> 00:09:02.680 In the case of a commodity, stocks would be withheld in expectation of a rise in demand 89 00:09:02.680 --> 00:09:10.380 and price, and then released, thereby effecting a more rapid transition to the price eventually 90 00:09:10.380 --> 00:09:40.380 The Theory of Money and Credit 91 00:09:40.380 --> 00:09:43.100 of Basic Time Preferences. 92 00:09:43.100 --> 00:09:50.300 Just as speculative errors in regard to commodity prices cause losses and impel further change 93 00:09:50.300 --> 00:09:58.100 to the real underlying price, so speculative errors will be self-correcting here, too, 94 00:09:58.100 --> 00:10:04.820 and lead the rate of interest to the height determined by underlying time preferences. 95 00:10:04.820 --> 00:10:11.080 The absurdity of separating the long-run and the short-run interest rates becomes evident 96 00:10:11.080 --> 00:10:18.740 when we realize that the basic interest rate is the natural rate of interest on investments, 97 00:10:18.740 --> 00:10:22.080 not interest on the producer's loan market. 98 00:10:22.080 --> 00:10:27.940 We have already seen the essential identity of the rate of earnings on the loan market 99 00:10:27.940 --> 00:10:30.220 with that on the stock market. 100 00:10:30.220 --> 00:10:35.860 If we consider the stock market, it becomes obvious that there is no distinction in rates 101 00:10:35.860 --> 00:10:39.860 between short-run and long-run investments. 102 00:10:39.860 --> 00:10:44.540 Different firms engage in stages of production of varying lengths. 103 00:10:44.540 --> 00:10:51.300 Yet the stock market equates the rate of interest on all investments, obliterating the differences 104 00:10:51.300 --> 00:10:57.700 in time structure so thoroughly that it becomes difficult for many writers to grasp the very 105 00:10:57.700 --> 00:11:01.200 concept of period of production. 106 00:11:01.200 --> 00:11:07.100 But since the operations of the stock market and the loan market are essentially the same, 107 00:11:07.100 --> 00:11:13.380 it is obvious that there is no difference in causal explanation between short-run and 108 00:11:13.380 --> 00:11:15.900 long-run interest rates. 109 00:11:15.900 --> 00:11:22.080 Those writers who postulate an essential difference between the nature of long-run and short-run 110 00:11:22.080 --> 00:11:29.160 and rates have been misled by a common penchant for considering the time market as confined 111 00:11:29.160 --> 00:11:37.240 exclusively to the loan market, when in fact the loan market is only a dependent one. 112 00:11:37.240 --> 00:11:43.280 In actual practice, it may well happen that either the short-run loan market or the long-run 113 00:11:43.280 --> 00:11:48.040 market may change first, with the other market following. 114 00:11:48.040 --> 00:11:55.040 Which market characteristically changes first is the outcome of the concrete conditions.