A:

Interest rates – especially nominal interest rates – are ultimately decided by individual preferences for liquidity and current consumption. However, lack of monetary policy influence meant that nominal interest rates in the United States were more flexible before the passing of the Federal Reserve Act of 1913. However, that doesn't mean that interest rates were always free of central bank influence or the effects of money creation.

The only period in U.S. history that was free of centralized national banking control fell between 1837 and 1863. From 1863 until 1913, banks needed national charters to operate; still, no central bank existed.

What Determines Nominal Interest Rates

Nominal interest rates are determined by the supply and demand for money. In economic terminology, the nominal interest rate represents the opportunity cost of money. Nominal interest rates tend to rise when the opportunity cost for money is low. Conversely, they tend to drop when the opportunity cost of money is high.

Interest rates tend to be low when the demand for present money is low and high when present demands for money are high. There are several factors that can raise the demand for present money. Consumers might want more present goods and need more cash. The future returns of investments might appear to be too risky. Sometimes people might prefer feeling of solvency and safety by holding cash.

How the Federal Reserve Affects Nominal Interest Rates

It would be technically incorrect to state that the Federal Reserve sets the interest rate. The Federal Reserve actually has only limited control over long-term real interest rates. It does influence the nominal rate of interest for loanable funds by affecting the money supply.

Suppose that the nominal interest rate for short-term debt is at 4%. The Federal Reserve can engage in open market operations by purchasing additional government bonds or other assets. Since the Fed creates new money to make these purchases, the total supply of money in the economy increases. If the Fed targets a 3% interest rate, it can continue to purchase assets and create new money until it sees interest rates drop to 3%.

If the Fed wants to raise nominal interest rates, it sells back bonds or other assets. This drains money out of circulation, lowering its supply.

Nominal Interest Rates Without the Federal Reserve

The demand for present funds relative to future funds was often much higher before the Federal Reserve. From 1831 to 1913, the short-term interest rate on debt exceeded 12% on more than 10 occasions; almost all occurred during the free banking period between 1837 and 1863. A 12% rate has only been experienced once since 1913.

The short-term interest rate also never dropped below 3% between 1831 and 1913. Since the Fed was established, the short-term rate has been below 3% (far below) for multiple years. The nominal rate was still determined by supply and demand for money, but the supply of money appeared to be much more natural (i.e. not strategically set).

It was commonplace for the economy to experience deflation and for the yield curve to be negative during the 19th century. Increased productivity led to higher purchasing power over time, so the interest rate on longer-term investments didn't need to be as high.

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