The General Theory of the Rate of Interest

Chapter 11 shows that there are forces causing the rate of investment to rise or fall so as to keep the rate of return on investments equal to the rate of interest.

Yet the rate of return on investments is, in itself, a different thing from the rate of interest.

• The investment-demand curve governs how loanable funds are turned into new investment. [demand for money for investment]
• The rate of interest governs how funds are currently supplied. [supply of money to invest]

What determines the rate of interest?

The answers are in Chapter 14 and its Appendix. They make the rate of interest depend on the interaction of:

• the investment-demand curve [demand for money for investment] with
• the psychological propensity to save [desire to supply money for investments]

The rate of interest is the balancing factor between the savers and the investors.

• It converts the desire to save into a real action of saving into a new investment- This saving is equal with the supply of saving from the community’s desire to save.

But this breaks down as soon as we see that it is impossible to deduce the rate of interest merely from a knowledge of the supply and demand for savings.

Our Love for Cash Determines Interest Rates

The psychological time-preferences of an individual need two sets of decisions.

1. The propensity to consume= This is his time-preference or the need for cash now

How much money does he need now?

2. His liquidity preference= This is his need or love for cash in the future

How much money does he not need now?

The mistake of previous theories on the rate of interest is that they neglect the liquidity preference. This neglect is what we are repairing. The rate of interest cannot a revenue from saving or waiting*. A man who hoards cash in his room will not earn interest.

Instead, I define rate of interest as “the reward for parting with cash for a specified period”.

• This is because the rate of interest is just the inverse proportion between cash and what can be obtained for parting with that cash in exchange for a debt for a certain time.

• It is a measure of the unwillingness of those who have cash to part with their control over cash.
• It is not the “price” which brings into equilibrium the demand savings with the readiness to create savings.
• It is the “price” which equilibrates the desire to hold wealth as cash with the available quantity of cash.

If the rate of interest is:

• lowered, then it means the reward for parting with cash is reduced
  • This would cause the amount of cash which the public would wishes to hold to exceed the available supply.
• raised, then there would be a surplus of cash in the banks

Thus, the ratio of the amount of cash and the love for future cash determines the actual rate of interest.

The love for future cash is a potentiality which determines the amount of cash that the public will hold for a given interest rate.

M = L(r)

• r is the rate of interest
• M is the quantity of cash
• L is the function of the love of future cash

This is how the quantity of cash enters into the economic scheme.

Why does the love for future cash exist?

Anciently, the use of money was distinguished into:

1. A tool of trade

We gain the convenience of liquidity by sacrificing a certain amount of interest.

But the intrest rate is never negative. Why should anyone prefer to hold his wealth in a form that yields no interest to holding it in a form that yields interest?

A full explanation is complex and is in Chapter 15.

2. A store of wealth

The uncertainty of future interest rates prevents the love of cash as a means for keeping wealth.

If all future interest rates could be foreseen, then the present rates could then be adjusted.

For example, if 1dr is the value in the present year 1 of £1 deferred r years, and it is known that ndr will be the value in the year n of £1 deferred r years from that date, we have:

ndr = ndn+r / 1dn

It follows that the rate at which any debt can be turned into cash n years is given by two out of the complex of current interest rates.

• If the current interest rate is positive for debts of every maturity, it would be more advantageous to get into debt than hold cash.
• If, on the contrary, the future interest rate is uncertain, we cannot safely infer that ndr will be equal to 1dn+r / 1dn when the time comes.
• If a need for cash arises before the expiry of n years, there is a risk of a loss being incurred in buying a long-term debt and subsequently turning it into cash, as compared with holding cash.

The actuarial profit or mathematical expectation of gain calculated based on the existing probabilities. If it can be so calculated (which is doubtful) it must be enough to compensate for the risk of disappointment.

The uncertainty of future interest rates in organised debt-markets also fuels the love for future cash. This is because different people will estimate the prospects differently*. Anyone who thinks differently from the predominant market trends might keep cash in order to profit against the market.

This is closely analogous to the marginal efficiency of capital.

• The marginal efficiency of capital is fixed not by the “best” opinion, but by the market valuation as determined by mass psychology.
• Thus the expectations of the future of the rate of interest as fixed by mass psychology have their reactions on liquidity-preference.

Those betting on cash and those betting against cash creates a balance as the market price.