Understanding Interest Rates

What is the interest rate? Is it something that the RBI sets, or is it something inherent to the economy? If the latter, how does it originate? These are tricky questions, but understanding this key concept is particularly important for an income investor.

The interest rate of an economy is simply the price spread in the production structure.

That statement seems to be economist mumbo-jumbo, but bear with me for a while and it will start to make sense. Let’s dissect it in parts.

What is the production structure?

You’re probably reading this article on your tablet or phone. The device didn’t magically fall from the sky. It was produced. Probably in a factory in China, from where it was shipped to a distributor and eventually found its way into your hands. The factory making the device got the components from its suppliers, who in turn got their components from their suppliers and so on. That’s exactly what the production structure is, the system which converts producers’ goods into the consumer goods that you and I use in our daily lives.

Stages of production

Consumer good: iPhone 6s

First stage of production: iPhone 6s at the Apple store

Second stage of production: iPhone 6s at the Apple store’s warehouse/distributor

Third stage of production: iPhone 6s at Foxconn China

Fourth stage of production: iPhone 6s components for assembly

and so on…

You get the idea. At every stage, the iPhone 6s moves along the production structure and comes closer and closer to becoming a consumer good. Stated generically:

 

Now, for the sake of simplicity, let’sassume that each stage of production takes a year. A capitalist owns each stage of the production structure. The stage 1 capitalist obtains Producer good 1 and engages land and labour factors to work on it for a year to produce the Consumer good, the sale of which gives him his profit. The stage 4 capitalist obtains Producer good 4, engages land and labour factors for a year andproduces Producer good 3, which he sells to the stage 3 capitalist at a profit, and so on.

Putting some numbers in,The stage 1 capitalist invests Rs. 95/- for a year and makes Rs. 100/-, gaining Rs. 5/-. The stage 2 capitalist invests Rs. 76/- for a year and makes Rs. 80/-, gaining Rs. 4/- and so on. While their gains differ, what’s common across all the stages is that they all earn approx. 5% on their invested capital. This is known as the price spread and this is what determines the interest rate in the economy.

What happens if one stage has a higher price spread than another? An arbitrage opportunity arises, capital moves from the less profitable to the more profitable stage until the opportunity disappears. If the price spreads are better for one consumer good over another, arbitrage will again ensure that capital is moved until both the price spreads are uniform.

Gains to capitalists

The capitalists get their gains for waiting. They advance money in the present in order to receive money in the future. Their gain from waiting is interest, and their rate of return is the interest rate.

The interest rate of an economy is simply the price spread in the production structure.

While the RBI may proclaim repo rates, reverse repo rates and prime rates and keep tweaking them, they do not set interest rates. Interest rates are derived from the capitalists in an economy who advance capital in order to keep the production process going. The market is constantly determining the interest rate, moving capital across the production structure, ensuring that price spreads in an economy move towards an equilibrium.

Parting thought:

“Interest is the difference in the valuation of present goods and future goods; it is the discount in the valuation of future goods as against that of present goods.” – Ludwig von Mises, economist

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