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From Chapter 12: [Why the Policy of Easy Money Raises Interest Rates] (p. 521)

This excerpt is taken from George Reisman, Capitalism: A Treatise on Economics. Ottawa, Illinois: Jameson Books, 1996. Copyright © 1996 by George Reisman. All rights reserved. May not be reproduced in any form without written permission of the author. The following limited exception is granted: Namely, provided they are reproduced in full and include this copyright notice and are made for noncommercial use, i.e., for use other than for sale, including use as part of any publication that is sold, copies of this excerpt may be downloaded into personal computers and distributed electronically or on paper printouts from a personal computer; reproduction on the internet is permitted provided the copy of the excerpt is accompanied by the following link to the Jefferson School's home page (which may, and hopefully will, be displayed elsewhere and more prominently): The Jefferson School of Philosophy, Economics, and Psychology. This limited right of reproduction expires on December 31, 1999.

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Here I must briefly digress, because the [direct] connection I have just described between the increase in the quantity of money and the rate of interest is the opposite of that which is usually believed to exist. The usual belief is that an increase in the quantity of money entering the loan market reduces the rate of interest. In view of the prevalence of this belief, some further comments on my part are in order.

An increase in the quantity of money can reduce the rate of interest only temporarily. As soon as the new and additional money is borrowed and spent, it begins to raise sales revenues and profit margins, and thus the rate of profit. The rise in the rate of profit then raises the rate of interest. To prevent the rate of interest from rising in the face of the higher rate of profit, an acceleration in the rate of credit expansion would be necessary. The effect of such an acceleration would be a still more rapid rate of increase in the volume of spending and thus in business sales revenues, with the result that profit margins and the rate of profit would rise still higher, which, of course, would operate all the more powerfully to raise the rate of interest. To prevent the rate of interest from rising at this point, an even more rapid rate of credit expansion would be required, which would cause yet a still higher rate of profit, and so on. Thus, the use of credit expansion to prevent the rise in the rate of interest that results from an increase in the quantity of money would quickly entail such enormous rates of increase in the quantity of money as to destroy the monetary system.

For example, starting with a rate of profit of 4 percent and a rate of interest of 3 percent, credit expansion might temporarily reduce the rate of interest to, say, 2.75 percent. But once the new and additional money succeeds in raising sales revenues and profit margins, the rate of profit rises to, say, 4.25 percent. To keep the rate of interest at 2.75 percent in the face of this higher rate of profit, requires more credit expansion than before. If it is forthcoming, then the rate of profit rises perhaps to 4.5 percent, which means that still more credit expansion will be required if the rate of interest is to be held at 2.75 percent. Since the difference between the rate of profit and the rate of interest steadily widens, making borrowing more and more profitable, exponentially increasing amounts of credit expansion would be required to prevent the rate of interest from rising. To avoid rapid destruction of the monetary system, there is no practical alternative but to allow the rate of interest to follow the rate of profit on up as the quantity of money increases. In pattern, the rise in interest rates in the United States over the thirty-five years following World War II is explainable on the basis of a progressively more rapid rate of increase in the quantity of money, taking place in large measure in the form of credit expansion.

The mistaken notion that increases in the quantity of money reduce the rate of interest is largely the result of thinking of the rate of interest as "the price of money" and then applying the principle that increases in supply reduce prices. A more accurate description of the rate of interest than the price of money is the difference between the money that is borrowed and the money that is repaid. Thus, for example, one should think of the payment of a 10 percent rate of interest on a one-year loan of a thousand dollars not as a price for the borrowing of the thousand dollars, but as the difference between the eleven hundred dollars that will have to be repaid and the thousand dollars that is borrowed. If one thinks of interest this way, then it is not surprising that interest rates turn out to be higher rather than lower as the consequence of an increasing supply of money. Because to the extent that more money exists and is spent and earned at the time of repayment than at the time of borrowing--which is the necessary consequence of an increasing quantity of money--correspondingly more money is available to be repaid and is thus likely to have to be repaid than would otherwise be the case.

Thus, the effect of a more rapidly increasing quantity of money and volume of spending has been shown to be to raise the rate of interest after temporarily reducing it. . . .