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Can you explain what actually is the reason/purpose of interest in our modern day monetary system?”

Money is endogenous in the modern monetary system. That means it can be created by any user within the system and can be created from what is really nothing more than an agreement between parties. The primary form of money in our system is bank deposits and they are created by banks when banks make loans. Private banks essentially control the primary payment system that we all use and so they create the primary form of money and maintain the system in which it is used. If you want to participate in the US economy to purchase goods and services then you need a bank account.

Banks make money by charging you a fee to use their system and to use the money they create within this system. Because the system is privately controlled there is an element of risk management in everything that a bank does. That is, if a bank doesn’t properly manage its risks it can end up like Washington Mutual or Northern Rock. Because banks are private profit maximizing entities they have to balance how they generate a profit and how much risk they take in the process of doing this.

The privately controlled element of this system creates competition which makes banks operate more efficiently and makes them accountable for how they operate their businesses. But since this payment system is so central to the health of the economy the payment system has a unique relationship within the economy. And as we’ve all discovered over the last 5 years when the payment system doesn’t work properly the whole economy stops working properly. And so you get this inherent and tricky mix between government intervention in the banking system and the way banks try to operate within their “free market” to compete. It’s all a bit messy because the banks are profit maximizing and risk taking entities who can, at times, threaten the health of the entire economy through their ability (or inability) to manage their risks in the pursuit of profit.

When a bank lends you money they are essentially allowing you to use their payment system for a fee. And they will assess this fee based on the duration in which you want to use that money and the risks you pose to using that system. So, a borrower with bad credit could be rejected from being allowed to use the payment system that banks operate. Or the banks could just choose to charge that person a very high fee (interest rate) to use the system. So, in its simplest form interest is just the fee that banks charge users of the payment system.

Of course, there are lots of instruments which convey a similar temporal relationship like stocks or corporate debt. These instruments convey a similar type of relationship where one party is again creating a financial instrument to obtain money and thereby paying someone a fee to use that money. So, for instance, a corporate bond is an agreement by a corporation to obtain bank deposits for a certain period of time at a certain interest rate. In the process of creating this instrument with lower moneyness than the bank deposit they will pay the lender a fee for the specific period. They are, in essence, convincing the bank deposit user to forgo using their bank deposits in exchange for a fee. So you can see how this process of financial asset creation can be thought of within the spectrum of moneyness with different entities creating different forms of money within that system….

I hope that helps answer the question.

So Cullen is essentially saying that ‘interest’ is the charge that banks make for you to access/use their systems.

Nonsense.

The fundamental problem is that economic theory today has seemingly forgotten what capital actually is. The abstraction of money is so prevalent, not that economists seem to understand money either, that capital and its function has been lost.

Take the mind experiment of Crusoe on the island alone. He has a bright idea to build a boat and a net to catch more fish. He has the idea, now, how to build the boat and net. Both will require time to build/make and both will require materials, which again require time to be gathered.

The time required to gather and manufacture his products, require him to forego time spent gathering food. He decides to gather extra food each day for 3 months and save it. Then when he is manufacturing his product, he can allocate time from gathering food to manufacturing his products, living off of his saved capital, viz. stored/saved food.

The saved food is present value consumption. It is valuable. More valuable than future value consumption. The future haul of food will however be far more using a boat and net than current production of food. The difference or discounted value is the return to capital. Whether this capital be the saved capital goods of stored food, or the capital goods manufactured, capital is critical to actioning an idea.

If however there was a second castaway, and instead of Crusoe ‘saving’ food [capital] he could borrow the food [loan]. The difference or interest rate, will be the future haul of food, which will however be far more using a boat and net than current production of food. The difference or discounted value is the return to capital and is the interest rate charged for the loan [food].

Another way of looking at it is if I want to manufacture a boat and I can borrow money [food] to do so: will the return exceed the cost of interest? If it does, I build the boat. If not, I don’t.

Or,

I manufacture wigits. I can borrow at an interest rate of 5%. My selling profit is 18%. My net profit is 13%. It is worth borrowing the capital.

When the interest rate is low, more projects of production will be profitable, the marginal project. When it’s high, less.

To explain interest as the bank charge…nonsense.

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