Chapter 14 Appendix

Interest Rates According to Different Economists Icon

January 14, 2020

THERE is not much discussion of the rate of interest in the works of Marshall, Edgeworth or Professor Pigou.

Alfred Marshall= Interest is the price of capital

Principles of Economics

**Interest is the price paid for the use of capital in any market.** It tends towards an equilibrium level such that the aggregate demand for capital in that market, at that rate of interest, is equal to the aggregate stock forthcoming there at that rate. If the market is small, such as a town, an increased demand for capital in it will be promptly met by an increased supply drawn from surrounding districts or trades. But if we are considering the whole world, as one market for capital, we cannot regard the aggregate supply of it as altered quickly and to a considerable extent by a change in the rate of interest. This is because the fund of capital is the product of labour and waiting. A rise in interest rates would incentivize the extra work and waiting, resulting in the total stock of capital. But it would not quickly amount to much, compared with this actual result. An increase in the demand for capital will therefore raise interest rates ahead of the increase of supply. This will cause capital to withdraw itself partially from those uses in which its marginal utility is lowest. The rise in interest rate will increase the total stock of capital only slowly and gradually, (p. 534)

His version is applicable to old investments of capital only in a very limited sense.

For instance, a trade capital of 7b pounds is invested in various industries this country at 3% net interest. This is convenient, but not accurate.

It is more accurate to say that if the net interest rate on new investments in each of those industries [i.e. on marginal investments] is 1%, then the aggregate net income from the total trade-capital invested, if capitalised at 33 years’ purchase (on 3% interest), would amount to 7b pounds.

The value of capital investment in land, building, etc. is the aggregate discounted value of its estimated future net incomes [or quasi-rents]. If its prospective income-yielding power should diminish, its value would fall accordingly and would be the capitalised value of that smaller income after depreciation” (p. 593).

*Keynes emphasizes the future, yet bashes the future.

Pigou= Interest is the reward of waiting for money to become capital

Economics of Welfare p.163

The nature of the service of ‘waiting’ has been much misunderstood. Sometimes it has been supposed to consist in: - the provision of money or - the provision of time People have argued that no contribution whatever is made by either to the dividend. Neither supposition is correct. ‘Waiting’ simply means postponing consumption which a person has power to enjoy immediately, thus allowing resources, which might have been destroyed, to assume the form of production instruments. The unit of ‘waiting ‘ is, therefore, the use of a given quantity of resources — for example, labour or machinery — for a given time. Generally, we may say that the unit of waiting is a year-value unit, or, in the simpler, if less accurate, language of Dr. Cassel, a year-pound. The common view is that the amount of capital accumulated is necessarily equal to the amount of ‘savings’ made in it. This is not totally correct because not all savings become capital. Instead, many are wasted.

Pigou believes that interest rate is determined by demand and supply of real capital which is in the control of a bank.

*Industrial Fluctuations (1st edn.), pp. 251-3

He argues that:

When bankers lend more to businesses, they make a forced levy of real things from the public. Thus, they increase the stream of real capital available for them, and cause a fall in the real rate of interest on long and short loans alike. The bankers’ rate for money is bound by a mechanical tie to the real rate of interest on long loans. But this real rate is not determined by conditions wholly outside bankers’ control.

I am perplexed by Marshall’s account. I think this is caused by Marshall taking the concept of “interest”, which belongs to a monetary economy, into a treatise which takes no account of money*. “Interest” has really no business to turn up at all in Marshall’s Principles of Economics, — it belongs to another branch of the subject.

*Translator’s note= Here, Keynes exposes that he is totally money-minded

Professor Pigou, conformably with his other tacit assumptions, leads us (in his Economics of Welfare) to infer that the unit of waiting is the same as the unit of current investment and that the reward of waiting is quasi-rent, and practically never mentions interest, — which is as it should be.

  • His Industrial Fluctuations is a study of fluctuations in the marginal efficiency of capital
  • His Theory of Unemployment is a study of what determines changes in the volume of employment (assuming there is no involuntary unemployment)

The rate of interest scarcely plays a larger part in either of those two studies.

Nevertheless, these writers are not dealing with a non-monetary economy (if there is such a thing). They quite clearly presume that money is used and that there is a banking system.

Ricardo’s Theory in Principles of Political Economy (p.511)

The interest of money is not regulated by the rate at which the Bank will lend, whether it be whatever percent, but by the rate of profit which can be made by the employment of capital. This is total independent of the quantity or of the value of money. The amount that a Bank lends cannot permanently alter the market rate of interest. It would alter only the value of the money [inflation]. Ten times more money might be required to carry on the same business. Borrowing money from banks thus depends on the comparison between: - the rate of profits from the use of money, and - the interest rate at which the banks will lend - If banks charge less than the market rate of interest, money will flow out of the banks. - If they charge more than that rate, only prodigals will borrow.

This is more clear-cut than the definitions of later writers.

But as always with Ricardo, it is a long-period doctrine, with the emphasis on permanence.

It assumes the usual classical assumption that there is always full employment. If there is no change in the supply curve of labour in terms of productivity, there is only one possible level of employment in long-period equilibrium.

It assumes ‘ceteris paribus’, that there is no change* in psychological propensities and expectations other than those arising out of a change in money supply. In such a case, there is only one rate of interest which will be compatible with full employment in the long term.

*Translator’s note= The Classical notion is natural and correct because it occured before profit maximization (a concept from Mercantilism) was enshrined by the marginal revolution. The imposition of profit maximization is the colossal change in psychological expectations that rendered the Classical notion of interest invalid to Keynes, who lived in a time when money became the established religion and profit maximization the mode of worship.

Ricardo and his successors failed to see that even in the long term:

  • the volume of employment is not necessarily full but is capable of varying
  • to every banking policy there corresponds a different long-period level of employment so that there are a number of positions of long-period equilibrium corresponding to different conceivable interest policies on the part of the monetary authority.

*Translator’s note= Here, Keynes points to the power of banks in controlling employment, different from the time of Ricardo when they were in the power of entrepreneurs, merchants, and industrialists. This implies that banks in 1936 had already gained such an unnatural economic power. This is proven by giant banks such as JP Morgan and the Federal Reserve being established in the 1890s to the 1910s. This huge, but imperceptible, change was the necessary consequence of the marginal revolution.

Ricardo is correct if applied only to the money supply created by a central bank. It is true that interest rates would not change if the central bank held money supply at a fixed amount.

But if the central bank changes the money supply, such as by buying of selling bonds*, then the rate of interest at change. Ricardo expresses this in his quote above**.

*Translator’s note= According to Adam Smith, the buying and selling of bonds is a mercantilist tool **Keynes imposes his ideas onto Ricardo who clearly said that interest rates have nothing to do with the bank, but with the profits in society (in line with Adam Smith’s notions).

Under my notions, there are only two possible long-period positions:

  • full employment
  • employment level corresponding to the interest rate at which liquidity-preference becomes absolute (in the event of this being less than full employment)

The interest rate policy of the central bank will change the money supply. This makes it a real determinant into the economic scheme.

The last sentences of Ricardo’s statement shows that he was overlooking the possible changes in the marginal efficiency of capital according to the amount invested. But this again is for him to be consistent with his theory compared to those of his successors.

If the quantity of employment and the psychological human propensities are taken as given, then there is only one possible rate of accumulation of capital. Consequently, there is only one possible value for the marginal efficiency of capital.

Ricardo offers us the supreme intellectual achievement, unattainable by weaker spirits.

Professor von Mises= Interest is the ratio between the difference in the price of consumer goods to capital goods

His notion was adopted from him by Professor Hayek and Robbins.

According to them, changes in interest rate can be identified with changes in the relative price levels of consumption-goods and capital-goods.

By a somewhat drastic simplification, the marginal efficiency of capital is taken as measured by:

the supply price of new consumers’ goods = the supply price of new producers’ goods

This ratio is then identified with the interest rate. This makes a fall in interest rate favourable to investment. Therefore, a fall in the ratio of the price of consumers’ goods to the price of producers’ goods is favourable to investment.

Through this, a link is established between:

  • increased saving by an individual and
  • increased aggregate investment

Increased individual saving will:

  • reduce the price of consumers’ goods, and
  • a lesser fall in the price of producers’ goods

This means that a reduction in interest rate will stimulate investment.

A lowering of the marginal efficiency of capital has the opposite effect to what the argument assumes because investment is stimulated either by:

  • raising the schedule of the marginal efficiency or
  • lowering the interest rate

Professor von Mises confuses the marginal efficiency of capital with the rate of interest, causing their conclusions to be exactly the wrong way round.

Professor Alvin Hansen writes:

“Mises has suggested that the net effect of reduced spending will be a lower price of consumers’ goods. This would minimize the stimulus to invest in fixed capital.

This is incorrect. It is based on a confusion of the effect on capital formation of

(1) higher or lower prices of consumers’ goods, and (2) a change in the rate of interest.

Decreased spending and increased saving reduces consumer goods prices relative to that of producers’ goods.

But this, in effect, means a lower rate of interest, and a lower rate of interest stimulates an expansion of capital investment in fields which at higher rates would be unprofitable.”