Most experts agree that through the manipulation of short-term interest rates, the central bank by means of expectations regarding future interest rate policy, can also dictate the direction of long-term interest rates. In this way of thinking expectations regarding future short-term interest rates are instrumental in setting the long-term rates. (Note the long-term rates are an average of short-term rates in this way of thinking.)

Given the supposedly almost absolute control over interest rates, the central bank by correct manipulations of short-term interest rates could navigate the economy along the growth path of economic prosperity, so it is held. (In fact, this is the mandate given to central banks.)

For instance, when the economy is thought to have fallen below the path of stable economic growth it is held that by means of lowering interest rates the central bank could strengthen aggregate demand. This in turn will be supportive in bringing the economy onto a stable economic growth path.

Conversely, when the economy becomes “overheated” and moves onto a growth path above that which is deemed as stable economic growth, then by lifting interest rates the central bank could slow the economy back onto the path of economic stability.

But is it valid to suggest that the central bank is the key factor in the determination of interest?

Individuals Time Preferences and Interest Rates

According to great economic thinkers such as Carl Menger and Ludwig von Mises, interest is the outcome of the fact that every individual assigns a greater importance to goods and services in the present against identical goods in the future.

The higher valuation is not the result of capricious behavior, but because of the fact that life in the future is not possible without sustaining it first in the present. According to Carl Menger,

Human life is a process in which the course of future development is always influenced by previous development. It is a process that cannot be continued once it has been interrupted, and that cannot be completely rehabilitated once it has become seriously disordered. A necessary prerequisite of our provision for the maintenance of our lives and for our development in future periods is a concern for the preceding periods of our lives. Setting aside the irregularities of economic activity, we can conclude that economizing men generally endeavor to ensure the satisfaction of needs of the immediate future first, and that only after this has been done, do they attempt to ensure the satisfaction of needs of more distant periods, in accordance with their remoteness in time.1

Hence, various goods and services that are required to sustain man’s life at present must be of a greater importance to him than the same goods and services in the future.

On this Menger wrote,

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. Command of the means for the maintenance of our well-being at some distant time avails us little if poverty and distress have already undermined our health or stunted our development in an earlier period.2