Interest Rates and Monetary Systems: A Historical Perspective
Interest Rates and Their Determinants
Interest rates are the “price of debt or credit” and are determined by supply and demand.
An increased supply of commodity money leads to more lenders. The supply of credit increases, and people have more money saved. Consequently, an increase in the amount of money results in a reduction of interest rates.
This leads to:
- Investment
- Consumption
- Economic growth
The relationship can be summarized as:
+ Commodity Money + Saved Money + Supply Credit → Low Interest Rates = Economic Growth
Historical Evolution of Monetary Systems
Commodity Money and Its Limitations
Commodity money, such as gold, suffered from a limited supply (natural resources), leading to lower prices of other commodities (deflation). This resulted in expensive interest rates, hindering investment and economic growth.
Two-Commodity Monetary Systems
Two-commodity monetary systems, like gold-silver, were attempted. However, without authority to correct exchange rates, silver often disappeared, leaving only gold. This occurred in several countries, most notably England in the 17th century.
The Rise of Fiduciary Money
Fiduciary money, such as certified and non-counterfeitable papers, was exchanged for commodity money. If not all notes were exchanged simultaneously, the issuer could issue more money, temporarily avoiding a lack of supply and deflationary pressures.
This allowed governments to influence price levels and interest rates beyond the limitations of commodity-based systems.
Transition to Fiat Money
To better manage the economy, governments progressively abandoned commodity-money systems in the mid-20th century. The need to pay taxes and fines ensured the acceptance of government-issued money.
After World War I and the Great Depression, deflation was aggravated by commodity money. The need to increase the money supply forced states to move away from commodities, adopting pure fiat money in all countries.
Commodity Money and Its Impact
The value of commodity money is tied to its production costs and demand. It has no fixed price and fluctuates constantly. Prices of all goods depend on the cost of the commodity money.
Higher production costs or demand for commodity money lead to higher prices and lower prices for other commodities (deflation). Conversely, lower production costs for other commodities lead to lower prices and a higher price for money (inflation).
Deflationary Pressures
Commodity-money systems tend towards deflation, negatively impacting GDP. This is due to:
- Difficulties in debt repayment.
- Reduced profits.
- Disincentives for consumption and investment.
Causes of Deflation
Deflation can be caused by:
- Technological improvements, reducing production costs.
- Economic growth, increasing the demand for money.
Capitalism and Free Trade
The rise of capitalism introduced new markets and customers. This expansion was driven by the desire of lords to increase their economic power and through colonization, leading to forced migrations and the expansion of free trade.
Free trade has taken many forms, always relying on the Ricardian Theory of Comparative Advantage. Specialization and exchange are the most efficient ways to acquire goods, both nationally and internationally.
If nations specialize in what they have the lowest opportunity cost, the total production is greater than what isolated countries could produce. This applies not only to producers but also to entire nations, enabling efficient international trade.
Challenges to Capitalism
It is difficult to imagine a capitalist world where economic agents would not seek to maximize income and would not pay for the costs of controlling agreements. It is also difficult to imagine a world where there are no improvements in technology or productivity, or where the market demands are not met.
Ricardo’s mechanism allowed competing firms to achieve results equivalent to those that would have been reached if there had been cooperation among economic agents.
Competitiveness and International Trade
The following relationships exist:
- Low competitiveness → Gold outflow → Deficit → Deflation (+P) → Better Comp
- High competitiveness → Gold inflow → Surplus → Inflation (-P) → Worse Comp
Non-competitive countries tend to become more competitive in the international arena due to declining costs, while the opposite happens with more competitive countries. This leads to specialization in production based on lower opportunity costs, resulting in increased product availability for all countries.