When discussing the market for money balances, many reputable macroeconomics and money and banking textbooks say that the price of money is the interest rate. This ‘liquidity preference’ theory is misguided. The kernel of truth therein is that, in holding higher money balances, an individual is forsaking earning a nominal rate of return on assets that could have been purchased with those balances. But this has no bearing on the fact that it is not the interest rate that equilibrates the market for money balances. Instead, it is the purchasing power of money that equilibrates the money market.
Interest, properly understood, is the price of time. It is what is given up in exchange for securing capital. Interest rates are determined in loanable funds markets, not in individuals’ decisions to hold additional money balances. While there are spillover effects from individuals who want to build up, or spend down, held money balances, these spillover effects do not change the fact that interest rates do not clear the market for money.
The price of money is a function of the prices of all other goods and services in the economy. Many economists proxy the price of money using the inverse of an aggregated price index. All else being equal, a higher price level implies a lower price of money; a lower price level implies a higher price of money. When individuals attempt to adjust their money balances, they are trying to secure a specific amount of purchasing power for their money balances, which is determined by their nominal balances in relation to these balances’ ability to command real goods and services.
This may seem like a mere technicality within specialized macroeconomic debate. In fact, it is foundational to our understanding of how economies work. Treating interest as the price of money leads naturally to embracing a framework where central banks actively try to alter interest rates (in the short run only) so that the market for money balances is ‘well behaved.’ Economists who recognize that interest is actually the price of time will tend to worry policy of this kind will result in faulty price signals for capital, resulting in investors undertaking fundamentally unsustainable projects. These paradigms are incompatible. Furthermore, I contend that the former—the standard macroengineering approach of today’s monetary economists—is fundamentally destructive of economic wellbeing.
The market for money and the market for capital are two very different markets. Confusing them has caused no small amount of macroeconomic mischief. Getting the distinction between these two markets right is necessary for intellectually sound and socially responsible monetary scholarship.