Superphysics
Investment Rate versus Interest Rates
7 minutes • 1388 words
In truth, the classical theory has not been alive to the relevance of changes in the level of income or to the possibility of the level of income being actually a function of the rate of the investment*.
Superphysics Note
This is illustrated by investment versus interest rates.
In this diagram, the amount of investment (or saving) I is measured vertically, and the rate of interest r horizontally.
X1X1’ is the first position of the investment demand-schedule, and X2X2’ is a second position of this curve.
The curve Y1 relates the amounts saved out of an income Y1 to various levels of the rate of interest, the curves Y2, Y3, etc., being the corresponding curves for levels of income Y2, Y3, etc.
Let us suppose that the curve Y1, is the Y-curve consistent with an investment demand-schedule X1X1’, and a rate of interest r1.
If the investment demand-schedule shifts from X1X1’ to X2X2’, income will, in general, shift also. But the above diagram does not contain enough data to tell us what its new value will be.
Therefore, not knowing which is the appropriate Y-curve, we do not know at what point the new investment demand-schedule will cut it.
If, however, we introduce the state of liquidity-preference and the quantity of money and these between them tell us that the rate of interest is r, then the whole position becomes determinate.
For the Y-curve which intersects X2X2’ at the point vertically above r2, namely, the curve Y2, will be the appropriate curve.
Thus the X-curve and the Y-curves tell us nothing about the rate of interest. They only tell us what income will be, if from some other source we can say what the rate of interest is.
If nothing has happened to the state of liquidity-preference and the quantity of money, so that the rate of interest is unchanged, then the curve Y'2 which intersects the new investment demand-schedule vertically below the point where the curve Y1 intersected the old investment demand-schedule will be the appropriate Y-curve, and Y'2 will be the new level of income.
Thus, the functions used by the classical theory, namely, the response of investment and the response of the amount saved out of a given income to change in the rate of interest, do not furnish material for a theory of the rate of interest.
But they could be used to tell us what the level of income will be, given (from some other source) the rate of interest.
Alternatively, what the rate of interest will have to be, if the level of income is to be maintained at a given figure (eg. the level corresponding to full employment).
The mistake originates from regarding interest as the reward for waiting as such, instead of as the reward for not-hoarding; just as the rates of return on loans or investments involving different degrees of risk, are quite properly regarded as the reward, not of waiting as such, but of running the risk.
There is, in truth, no sharp line between these and the so-called “pure” rate of interest, all of them being the reward for running the risk of uncertainty of one kind or another.
Only in the event of money being used solely for transactions and never as a store of value, would a different theory become appropriate.[6] There are, however, two familiar points which might, perhaps, have warned the classical school that something was wrong.
In the first place, it has been agreed, at any rate since the publication of Professor Cassel’s Nature and Necessity of Interest, that it is not certain that the sum saved out of a given income necessarily increases when the rate of interest is increased; whereas no one doubts that the investment demand-schedule falls with a rising rate of interest.
But if the Y-curves and the X-curves both fall as the rate of interest rises, there is no guarantee that a given Y-curve will intersect a given X-curve anywhere at all.
This suggests that it cannot be the Y-curve and the X-curve alone which determine the rate of interest.
In the second place, it has been usual to suppose that an increase in the quantity of money has a tendency to reduce the rate of interest, at any rate in the first instance and in the short period.
Yet no reason has been given why a change in the quantity of money should affect either the investment demand-schedule or the readiness to save out of a given income.
Thus, the classical school had a different theory of interest rate in Volume 1
- They dealt with the theory of value from what they have had in Volume 2 dealing with the theory of money.
They have seemed undisturbed by the conflict and have made no attempt to build a bridge between the two theories.
The classical school proper, that is to say; since it is the attempt to build a bridge on the part of the neo-classical school which has led to the worst muddles of all.
The latter inferred that there are 2 sources of supply to meet the investment demand curve:
- savings proper, which are the savings dealt with by the classical school,
- plus the sum made available by any increase in the quantity of money (this being balanced by some species of levy on the public, called “forced saving” or the like).
This leads on to the idea that there is a “natural” or “neutral”[6] or “equilibrium” interest rate.
- The interest rate which equates investment to classical savings proper without any addition from “forced savings”
and finally to what, assuming they are on the right track at the start, is the most obvious solution of all, namely, that, if the quantity of money could only be kept constant in all circumstances, none of these complications would arise, since the evils supposed to result from the supposed excess of investment over savings proper would cease to be possible.
The traditional analysis is faulty because it has failed to isolate correctly the independent variables of the system.
The determinates of the economic system are:
- Saving
- Investment
- the propensity to consume
- the marginal efficiency of capital curve
- the interest rate.
These determinants are themselves complex. Each is affected by prospective changes in the others.
But they remain independent in the sense that their values cannot be inferred from one another.
The traditional analysis has been aware that saving depends on income.
- But it has overlooked the fact that income depends on investment.
When investment changes, income must necessarily change in a degree necessary to make the change in saving equal to the change in investment.
Those [classical] theories are not successful in making the interest rate depend on “the marginal efficiency of capital”.
In equilibrium, the interest rate will be equal to the marginal efficiency of capital.
- This is because it will be profitable to increase (or decrease) the current scale of investment until the point of equality has been reached.
But to make this into a theory of interest rates or to derive the interest rate from it involves a circular argument, as Marshall discovered.
This is because the “marginal efficiency of capital” partly depends on the scale of current investment.
We must already know the interest rate before we can calculate what this scale will be.
The means that the output of new investment will be pushed to the point at which the marginal efficiency of capital becomes equal to the interest rate.
The marginal efficiency of capital curve tells us the point where the output of new investment will be pushed, given the interest rate.
- It does not tell us what the interest rate is
This has the most fundamental theoretical and practical significance.
Previously, economists assumed that:
- a decrease in spending will lower the interest rate
- an increase in investment to raise it.
But these 2 quantities determine the aggregate volume of employment, not the interest rate.
- This changes our outlook on the mechanism of the economic system
A decreased readiness to spend will be looked on in quite a different light if, instead of being regarded as a factor which will, cet. par., increase investment, it is seen as a factor which will, cet. par., diminish employment.
