The Essential Properties of Interest and Money

The interest rate of money sets a standard to which the marginal efficiency of a capital-asset must attain if it is to be newly produced.

• This makes it play a part in limiting the level of employment.

At first sight, this is most perplexing.

It is natural to enquire wherein the peculiarity of money lies as distinct from other assets, whether it is only money which has a rate of interest, and what would happen in a non-monetary economy.

The money-rate of interest is just the percentage excess of a sum of money contracted for forward delivery, e.g. a year hence, over what we may call the “spot” or cash price of the sum thus contracted for forward delivery.

For every kind of capital-asset, there must be an analogous interest rate on money.

For there is a definite quantity of (e.g.) wheat to be delivered a year hence which has the same exchange value to-day as 1000 quarters of wheat for “spot” delivery.

If the former quantity is 105 quarters, we may say that the wheat-rate of interest is 5 per cent. per annum; and if it is 95 quarters, that it is minus 5 per cent. per annum.

Thus for every durable commodity, we have am interest rate in terms of itself: -a wheat-rate of interest

• a copper-rate of interest
• a house-rate of interest
• a steel-plant-rate of interest

The difference between the “future” and “spot” contracts for a commodity, such as wheat, which are quoted in the market, bears a definite relation to the wheat-rate of interest.

But since the future contract is quoted in terms of money for forward delivery and not in terms of wheat for spot delivery, it also brings in the money-rate of interest.

Let us suppose that:

• the spot price of wheat is £100 per 100 quarters
• the price of the “future” contract for wheat for delivery a year hence is £107 per 100 quarters
• the money-rate of interest is 5%.

What is the wheat-rate of interest?

£100 spot will buy £105 for forward delivery, and £105 for forward delivery will buy (105/107).100 (=98) quarters for forward-delivery.

Alternatively, £100 spot will buy 100 quarters of wheat for spot delivery.

Thus 100 quarters of wheat for spot delivery will buy 98 quarters for forward delivery. It follows that the wheat-rate of interest is minus 2% per annum.[1]

It follows that there is no reason why their interest rates should be the same for different commodities,— why the wheat-rate of interest should be equal to the copper-rate of interest.

For the relation between the “spot” and “future” contracts, as quoted in the market, is notoriously different for different commodities.

It could be that the greatest of the own-rates of interest (as we may call them) which rules the roost (because it is the greatest of these rates that the marginal efficiency of a capital-asset must attain if it is to be newly produced); and that there are reasons why it is the money-rate of interest which is often the greatest (because, as we shall find, certain forces, which operate to reduce the own-rates of interest of other assets, do not operate in the case of money).

There are differing commodity-rates of interest at any time.

Exchange dealers know that the interest rate is not even the same in terms of 2 different moneys, e.g. sterling and dollars.

For here also the difference between the “spot” and “future” contracts for a foreign money in terms of sterling are not, as a rule, the same for different foreign moneys.

Now, each of these commodity standards offers us the same facility as money for measuring the marginal efficiency of capital.

For we can take any commodity we choose, eg. wheat; calculate the wheat-value of the prospective yields of any capital asset; and the rate of discount which makes the present value of this series of wheat annuities equal to the present supply price of the asset in terms of wheat gives us the marginal efficiency of the asset in terms of wheat.

If no change is expected in the relative value of two alternative standards, then the marginal efficiency of a capital-asset will be the same in whichever of the two standards it is measured, since the numerator and denominator of the fraction which leads up to the marginal efficiency will be changed in the same proportion.

If, however, one of the alternative standards is expected to change in value in terms of the other, the marginal efficiencies of capital-assets will be changed by the same percentage, according to which standard they are measured in. To illustrate this let us take the simplest case where wheat, one of the alternative standards, is expected to appreciate at a steady rate of a per cent. per annum in terms of money; the marginal efficiency of an asset, which is x% in terms of money, will then be x - a % in terms of wheat.

Since the marginal efficiencies of all capital-assets will be altered by the same amount, it follows that their order of magnitude will be the same irrespective of the standard which is selected.

If there were some composite commodity which could be regarded strictly speaking as representative, we could regard the rate of interest and the marginal efficiency of capital in terms of this commodity as being, in a sense, uniquely the rate of interest and the marginal efficiency of capital. But there are, of course, the same obstacles in the way of this as there are to setting up a unique standard of value.

The money-rate of interest has no uniqueness compared with other rates of interest.

What is special about the money-rate of interest that I gave it importance in the preceding chapters?

Why should the volume of output and employment be more intimately bound up with the money-rate of interest than with the wheat-rate of interest or the house-rate of interest?