By Eric Tymoigne
In Post 20, a lot is said about the role that the rate of return on financial instruments—the interest rate—plays on the pricing on securities, but little was said about what determines that rate of return. Two competing theoretical frameworks explain what influences the interest rate, one of them emphasizes the role of real factors and the other emphasizes monetary factors.
Real Theory of Interest Rate: Natural Interest Rate and Expected Inflation
Gross Substitution and Indifference Condition: Determinant of the Nominal Interest Rate
The real exchange framework (Post 12) emphasizes the role played by real variables in the decision-making process of any rational economic unit. People are not fooled by mere improvement in monetary income because they only care about improvement in purchasing power given that only consumption provides utility. Monetary instruments have no other purpose than to smooth market transactions, and preoccupation about the liquidity of balance sheets and monetary outcomes are irrelevant. Capitalism is equivalent to a barter economy that uses monetary instruments.
