Most people identify money as coins and bank notes but current accounts are also money. Economists identify different types of money. The most important ones are medium of exchange (M1) and store of value (M2). M1 includes coins, banknotes and current accounts in the hands of the public. M2 includes M1 as well as savings accounts and time deposits . In economic language M1 is real money while M2 also includes close substitutes for money such as savings. When money is put into a savings account, M1 decreases but M2 remains constant. If a loan is made, M1 increases and M2 also increases because M1 is part of M2.
For example, when Mark puts money in a savings account, he exchanges his money for a claim to receive money from the bank. For this he receives interest. The action of Mark decreases M1 but not M2. The bank can use this money to make a loan. For example, when Elise borrows the money from the bank and spends it, money is put back into circulation. In exchange for the money, Elise has now a debt to the bank on which she must pay interest. Because of the loan M1, M2 and debt increase with the same amount. Any increase in M2 is backed with an increase in debt.
When Elise pays back the loan, M1, M2 and debt decrease with the amount of the loan. When Mark exchanges his savings for money, M1 increases but M2 does not change. When Mark puts money in a savings account and Elise takes out a loan, the amount of close substitutes for money in circulation (M2) increases, but the amount of money (M1) does not increase. If banks can only borrow against savings, Elise cannot borrow more than Mark has saved. With fractional reserve banking banks do not need savings to make loans. They can make loans if there is money in current accounts. Fractional reserve banking enables banks to inflate the amount of real money (M1), which tends to result in price inflation.
Liquid markets have blurred the distinction between money, money substitutes such as savings and liquid assets such as stocks. Money can often be withdrawn from savings accounts instantly at no cost and interest rates between savings accounts and current accounts do not differ much. The financialisation of assets has eroded the importance of traditional measures for money such as M1 and M2. Stocks and bonds can be sold instantly at little cost so there is little difference between money, stocks and bonds from a liquidity perspective.
Increases in M1 and M2 are monetary inflation while decreases in M1 and M2 are monetary deflation. There is a link between the amount of money and close substitutes in circulation and prices in the equation Money Stock (M) * Velocity (V) = Price (P) * Quantity (Q) where money stock (M) equals M1 + M2. Prices are not only determined by the money stock (M) but are also affected by quantity (Q) and velocity (V). The quantity (Q) is economic production so economic growth tends to reduce the price level. The velocity of M2 (Vm2) is lower than the velocity of M1 (Vm1) so a change in M2 does not have the same effect on the price level as a change in M1.
The price level (P) is often computed using a price index . The price index has some subjective elements affecting quantity (Q) such as the weighing of goods and services in the index and quality adjustments. For example, if computers make up 4% of expenses and computing power doubles every two years while the price remains the same and this is fully accounted for as a quality improvement, this could reduce the inflation figure with nearly 1% because the capabilities of computers increase with 22.5% every year. It is questionable whether or not the utility value of computers has risen with the same amount. Policy makers like low inflation figures so price indexes should be regarded with caution.
Interest on money is a payment for deferred consumption. By deferring consumption, resources can be used for production and consequently it will facilitate future consumption . The main reasons for interest on money to exist are:
1. The return on capital;
2. The risks associated with lending out money (default and inflation);
3. Time preference because having money now represents more freedom than receiving it in the future.
In a competitive free market interest rates on money tend to reflect the productivity of capital. If they did not, and the risk/reward ratio of capital was better or worse, interest rates would adjust until they do reflect the productivity of capital . For example, when interest rates are low and the return on capital is high, then more people would be willing to invest in capital directly. Interest rates also reflect the expected rate of inflation and the risks associated with the borrower. Default and inflation are both risks associated with lending out money.
A time preference for money exists because it represents undifferentiated spending power. If you have money now then you can choose to buy something today or keep the money and buy something some day in the future. If you receive the money in the future, you do not have the freedom to spend it now. This contributes to positive nominal interest rates. Money does not depreciate like capital and this is a systemic inefficiency that contributes to interest on money. Nobody will accept negative nominal interest rates if money can be put in a safe at zero percent interest. It is reasonable to assume that if there is a holding fee on money, then people will be more willing to accept negative nominal interest rates.
For centuries usury laws have been enacted to protect the poor from unscrupulous lending practises by setting a maximum level of interest. Economists contend that usury laws in the past failed because the interest ceiling was set below the equilibrium market interest rate. The effect of the interest rate ceiling may have been that only wealthy people could borrow money and that the poor had to manage themselves . Insofar the poor could not borrow at all they may have been better off in the end, but many poor may have become victims of loan sharks.
It is often assumed that there is a risk free interest rate , for example on government bonds. Governments may not default outright but they can print money to pay off their debts, lowering the value of money. Another issue is that many economists assume that interest rates must be positive. There is a preference for having money now as money represents undifferentiated spending power. If you have the choice between 20,000 loafs of bread now or one loaf of bread each day for the next 20,000 days, you are likely to prefer one loaf of bread every day for the next 20,000 days. Most people will even prefer one loaf of bread each day for the next 1,000 days above 20,000 loafs of bread now, which implies a steep negative interest rate.
Assumptions about interest in mainstream economics may turn out to be fatal. Risk free interest is an illusion. Interest increases risk as compound interest is unsustainable. Money does not depreciate in nominal terms so people tend to prefer money in the present above the same amount of money in the future. If money depreciates over time like capital, for example by a demurrage, people prefer to have money at the time they need it in the same way they desire a loaf of bread when they need it. Interest causes economically thinking humans to deplete natural resources now and not to care for the future. The rationale of interest is that you can use up everything now, make lots of money in the process, and put this money on the bank at interest, and have even more in the future.
A ban on charging interest on money poses constraints on the funds available for borrowing. If the risk/reward ratio of capital is more favourable, interest rates cannot adjust upwards and direct investments will be preferred. As a consequence lending and borrowing is restrained and money substitutes (M2) will increase less relative to economic growth. As there will be less borrowing for consumption, the economy will not overheat due to unsustainable accelerated consumption. The value of money will increase as economic output increases and in this way the interest on money will reflect the return on capital. Consequently it will be possible to sustain borrowing and lending at zero percent interest.
Borrowers with a high risk profile cannot borrow at zero percent interest. They may be better off because they have to postpone consumption instead of paying usurious interest rates. They will end up having more purchasing power in the end. It is however likely that there will be schemes devised to chisel on any usury ban. Loan sharks may try to fill in the gap and black markets may emerge. Making charging interest on money illegal and nullifying loans with interest may help to alleviate this issue as it makes the risk of doing business for loan sharks prohibitively high, making black market interest rates prohibitively high for most prospective borrowers.