The Natural Rate of Interest

“liquidity” and “carrying-costs” are both a matter of degree.

The peculiarity of “money” consists in a high liquidity relatively to low carrying-costs.

A “non-monetary” economy is one in which there is no asset for which the liquidity-premium is always in excess of the carrying-costs.

• It only has particular consumables and particular capital equipments differentiated according to the character of the consumables which they can yield up over time.

Unlike cash, these deteriorate or involve expense if they are kept in stock.

• This expense is in excess of any liquidity-premium they have.

In such an economy, capital equipments will differ from one another:

1. in the variety of the consumables in the production of which they are capable of assisting
2. in the stability of value of their output (in the sense in which the value of bread is more stable through time than the value of fashionable novelties)
3. in the rapidity with which the wealth embodied in them can become “liquid”, in the sense of producing output, the proceeds of which can be re-embodied if desired in quite a different form.

The owners of wealth will then weigh the lack of “liquidity” of different capital equipments in the above sense as a medium in which to hold wealth against the best available actuarial estimate of their prospective yields after allowing for risk.

The liquidity-premium is partly similar to the risk-premium, but partly different.

The difference corresponding to the difference between the best estimates we can make of probabilities and the confidence with which we make them.[7]

In calculating the own-rate of interest we must allow for both:

• differences in liquidity
• differences in risk

There is no absolute standard of “liquidity” but merely a scale of liquidity.

• This scale is a varying premium in addition to the yield of use and the carrying-costs
• This yield and cost are the comparative attractions of holding different forms of wealth.

The conception of what contributes to “liquidity” is a partly vague one, changing from time to time and depending on social practices and institutions. The order of preference in the minds of owners of wealth in which at any given time they express their feelings about liquidity is, however, definite and is all we require for our analysis of the behaviour of the economic system.

Historically, land has had a high liquidity-premium in the minds of its owners.

• Land resembles money in that the following are very low:
  • its elasticities of production
  • its elasticities of substitution[8]

The desire to hold land might have historically played the same role in keeping up interest rates too high compared to the money-interest today.

The high interest rates from mortgages on land, often exceeding the probable net yield from cultivating the land.

• These are a familiar feature of many agricultural economies.

Usury laws have been directed primarily against this.

Everyone knows the people’s preference for present gratification:

• sustains the interest rate
• checks the accumulation of wealth

My Treatise on Money explained the natural rate of interest.

• It is the rate which preserved equality between the savings rate and the investment rate.
• It builds on Wicksell’s “natural rate of interest”
  • He defined it as the rate which would preserve the stability of price levels.

on this definition, a different natural rate of interest for each hypothetical level of employment.

And, similarly, for every rate of interest there is a level of employment for which that rate is the “natural” rate, in the sense that the system will be in equilibrium with that rate of interest and that level of employment.

Thus it was a mistake to speak of the natural rate of interest or to suggest that the above definition would yield a unique value for the rate of interest irrespective of the level of employment. I had not then understood that, in certain conditions, the system could be in equilibrium with less than full employment.

I thought before that the concept of a “natural” rate of interest* was most promising.

• But now it has nothing very useful to contribute to our analysis.
• It is merely the interest rate which will preserve the status quo.

In general, we have no predominant interest in the status quo as such.

If there is any such rate of interest, which is unique and significant, it must be the rate which we might term the neutral rate of interest,[10] namely, the natural rate in the above sense which is consistent with full employment, given the other parameters of the system; though this rate might be better described, perhaps, as the optimum rate.

I define the neutral rate of interest as that which prevails in equilibrium when output and employment are such that the elasticity of employment as a whole is zero.[11]

The above gives us the answer to the question as to what tacit assumption is required to make sense of the classical theory of the rate of interest.

This theory assumes either:

• that the actual interest rate is always equal to the neutral rate of interest in the sense in which we have just defined the latter, or
• alternatively that the actual rate of interest is always equal to the rate of interest which will maintain employment at some specified constant level. If the traditional theory is thus interpreted, there is little or nothing in its practical conclusions to which we need take exception.

The classical theory assumes that the banking authority or natural forces cause the market interest rate to satisfy one or other of the above conditions.

It investigates what laws will govern the application and rewards of the community’s productive resources subject to this assumption. With this limitation in force, the volume of output depends solely on the assumed constant level of employment in conjunction with the current equipment and technique; and we are safely ensconced in a Ricardian world.

Author’s Footnotes

1. This relationship was first pointed out by Mr. Sraffa, Economic Journal, March 1932, p. 50.

2. See Chapter 20.

3. This is a matter which will be examined in greater detail in Chapter 19 below.

4. If wages (and contracts) were fixed in terms of wheat, it might be that wheat would acquire some of money’s liquidity-premium; — we will return to this question in (IV) below.

5. See p. 172 above. 6. A zero elasticity is a more stringent condition than is necessarily required.

6. Cf. the footnote to p. 148 above.

7. The attribute of “liquidity” is by no means independent of the presence of these two characteristics. For it is unlikely that an asset, of which the supply can be easily increased or the desire for which can be easily diverted by a change in relative price, will possess the attribute of “liquidity” in the minds of owners of wealth. Money itself rapidly loses the attribute of “liquidity” if its future supply is expected to undergo sharp changes.

8. A mortgage and the interest thereon are, indeed, fixed in terms of money. But the fact that the mortgagor has the option to deliver the land itself in discharge of the debt — and must so deliver it if he cannot find the money on demand — has sometimes made the mortgage system approximate to a contract of land for future delivery against land for spot delivery. There have been sales of lands to tenants against mortgages effected by them, which, in fact, came very near to being transactions of this character.

9. This definition does not correspond to any of the various definitions of neutral money given by recent writers; though it may, perhaps, have some relation to the objective which these writers have had in mind. 11. Cf. Chapter 20 below.