Introduction

I have encountered numerous, and very certain statements about the Federal Reserve “changing rates.” I cannot, however, figure out how, in a logical and mathematically sound manner, any entity, even The Fed, can unilaterally “change rates.”

Instead of starting with an explanation of how one calculates interest rates, I thought I would begin with a more basic explanation of how people calculate prices (all prices). Although we cannot consider what we generally call interest rates a price, they have such a close relationship to prices that price determination seems like a good place to begin.

In the broadest terms, a price is the ratio of what one entity exchanges to receive something else in return. In the U.S., we express most prices in dollars. In other words, how many dollars does an actor have to give in order to receive something else in return?

We state prices in terms of goods prices, service prices, wages, and interest (not interest “rates”).

Values (Preferences)

The fundamental element in understanding prices is “economic value.” Although many have referred to “value” in long texts and presentations, “value” remains a very simple concept. Always and everywhere, economic value has only one source and one measure: individuals and their preferences.

Source of Value

Most theories of value describe some sort of intrinsic value. The good or service has economic value as part of its immutable character. Everyone in the market would see the same value. Various theories offer different explanations of how that value got there, but the value always travels with the good or service.

Carl Menger, through reason, realized that value theories had a major flaw: they lacked universality. Goods and services did not have the same value everywhere.

Every good or service must have the same source always and everywhere. Reason led Menger to understand that value always and everywhere had the same source: the individual. The same good might have value to one individual and little or none to another.

But how did they measure economic value?

Measure of Value

If individuals provided the only source of economic value, individual preferences provided the only measure of economic value. Economic value fell on an ordinal scale that changed constantly as people’s alternatives changed. Economic value had no cardinal scale as statisticians—and economists—would prefer.

Individual Preferences in a Market

To help understand a simple yet frequently confusing concept, I will present a few graphics.

The following chart shows the preferences of individuals in transactions A through L. The good or service in each transaction remains the same, but the potential buyers (black) and sellers (red) differ from transaction to transaction. In all cases, the buyers offer dollars; the sellers offer a fungible good (the same good).

This graph provides a hidden view of each participant’s preferences in this market. By “hidden,” I mean that we cannot see these preferences. They remain hidden in participants’ minds.

To further clarify, I will isolate participants’ preferences (still hidden) for transaction A.

Individual Preferences

The seller (red) will accept any dollar unit price above his lowest limit, indicated by the crosshatch.

The buyer (black) will offer any dollar unit price below his highest limit, indicated by the crosshatch.

Because the upper (buyer) and lower (seller) limits cross, the two can engage in an exchange.

Value Ranges

Up to this point, we know that, although no one can see, the preferences of the potential buyer and seller cross, but they have taken no action. That fact ends when the parties communicate bid and asked prices

To clarify, those consist of a “bid price” and an “asked price;” not a “price.”

Bid Price & Asked Price

The buyer, seeing a good he desires more than a certain amount of dollars, makes a bid (or offer). The seller, although he sees the “bid price” as acceptible asks for a little more: the “asked price.”

Now, for the first time, we have amounts that we can identify. (Remember, no one can see the ranges.)

Price

After some discussion, the buyer and sell inevitably agree to a “price.” Each departs the transaction with something they value more than what they gave up.

Price Patterns

When one looks at a series of prices from individual transaction one sees a “price pattern,” or a pattern of prices in individual transactions for a fungible good. From these patterns, statisticians and economists will report an average (or “market” price). You can decide whether you find “market prices” meaningful.

Notice that transactions F, J, and L did not close and therefore have no prices.

Conclusion

Actual prices, in any market—whether for goods, services, wages, or interest—do not become objective until after the conclusion of individual transactions. No set of magical “supply and demand curves” appears in the sky to show prices, and no entity can unilaterally control any price.

Marginal Interest Rates (commonly referred to as simply “interest rates”) do not represent prices, but they relate to prices. To understand interest rates well, it helps first to understand how individuals determine prices.

I hope that this description of prices will help you understand why The Fed cannot set any interest rates, which I will explain soon.