Hence, by popular thinking, liquidity, economic activity, and inflation expectations are seen as key factors in the interest rate determination process. Again, this process is set by the central bank’s monetary policies, which influences monetary liquidity. The monetary liquidity effect, in turn, gives rise to two other effects. This way of thinking originates from the writings of Milton Friedman.

The popular theory of the interest rate is not established from a theoretical framework that “stands on its own feet,” but derived from empirical observations. In this sense, theories of the interest rate do not explain, but only describe. Furthermore, such a theory will not be able to explain the formation of the interest rates in the absence of the central bank.

Time Preference and Interest Rates

Individuals must necessarily give attention to maintaining their lives—basic needs—before consideration of more distant wants. Time is always a consideration in human action. According to Carl Menger,

To the extent that the maintenance of our lives depends on the satisfaction of our needs, guaranteeing the satisfaction of earlier needs must necessarily precede attention to later ones. And even where not our lives but merely our continuing well-being (above all our health) is dependent on command of a quantity of goods, the attainment of well-being in a nearer period is, as a rule, a prerequisite of well-being in a later period.

This means that an individual assigns higher value to present goods over future goods, to present satisfaction over future satisfaction. For example, consider a case where an individual has just enough consumer goods to keep himself alive. This individual is unlikely to save those goods for later, let alone invest or lend his paltry means. The cost of doing so would be too high, and might even cost him his life. ………

When money is artificially inflated “out of thin air” and injected into the economy, this sets in motion an exchange of nothing for something. The earlier receivers of the recently-injected money can now divert to themselves consumer goods from the producers of these goods. In similarity to the counterfeiter, the printers and receivers of the inflated money can now increase the purchases of various assets, thus pushing their prices higher and their yields lower.

This also has the consequence of artificially lowering the interest rate, misleading entrepreneurs about the seeming profitability of certain long-term projects. Genuine growth can also take place alongside artificial growth, but the inflation has distorted the price and production structure, leading to a boom-bust cycle. However, once genuine savings start to decline, and since inflation cannot continue forever, time preferences and, consequently, the market interest rate is going to increase. This will reveal the unsound long-term projects and investments, leading to the bust of the boom-bust cycle.