The Exogeneity of Interest Rates

Abstract

The interest rate is the price of credit expressed as a percentage: the price paid for a loan of one unit of money in the present in return for a promise to repay one unit of money plus interest one year in the future. Classical economists analyzed the factors determining interest rates as real forces underlying the supply and demand for loanable funds.1 They concluded that real interest rates were determined by the real forces behind the demand for investment and the supply of saving, conventionally summarized under the headings “productivity” and “thrift.” Nominal interest rates comprised this real rate plus an “inflation premium,” which reflected the expected future rate of inflation over the maturity of the particular security.

The banking system has no direct control over the quantity of money; for it is characteristic of modern systems that the central bank is ready to buy for money at a stipulated rate of discount any quantity of securities of certain approved types. Thus it is broadly true to say that the governor of the whole system is the rate of discount.

John Maynard Keynes, 1930

The rate of interest is the reward for parting with liquidity for a specified period. … The rate of interest is not self-adjusting at a level best suited to the social advantage but constantly tends to rise too high. … In a world, therefore, which no one reckoned to be safe, it was almost inevitable that the rate of interest, unless it was curbed by every instrument at the disposal of society, would rise too high to permit of an adequate inducement to invest.

John Maynard Keynes, 1936: 167, 351

We intend to retain control over our domestic rate of interest, so that we can keep it as low as suits our own purposes, without interference from the ebb and flow of international capital movements or flights of hot money.

John Maynard Keynes, XXVII, House of Lords, 1944

The General Theory’s most momentous, radical and decisive service was to release the interest rate from its imprisonment in the mutual selfdeterminating equilibrium system of prices of goods in terms of goods, and to make it a response to uncertainty.

George L.S. Schackle, 1983