The economics of decentralized money and banking

The notion that the rate of interest is the price of money, a variable that equilibrates money demand and money supply, appears to have emerged as a direct translation of supply and demand as it operates on the goods market into the world of finance. This paper argues that the rate of interest should not be seen as an equilibrating mechanism of this sort, nor should it be treated as a natural tool for regulation of price levels; rather, it is the mechanism that, only under a properly designed decentralized monetary and banking system, however, maintains real capital equilibrium, regulating money flows between the real and the financial sectors. This process is negated by the centralized use of short-term interest rates as policy tools. It shows how, in a well-designed decentralized free banking system, bank credit extension would be counter-cyclical to the liquidity fluctuations of the public.