The Theory of Interest

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Price and output Determination Under Perfect Competition. Price and Output Determination Under Monopoly. Principles and Theories of Macro Economics. National Income and Its Measurement. Principles of Public Finance. Public Revenue and Taxation. National Debt and Income Determination. Fiscal Policy. Determinants of the Level of National Income and Employment. Determination of National Income. Theories of Employment. Theory of International Trade. Balance of Payments.

The formula connecting the two does not enable us, in the least, to find out how hot or cold the weather is.

⏳ Time Preference - Interest Rates

While the deviations of the money rate of interest from the real rate are of tremendous practical importance, they may be regarded as belonging more to the problem of money than to the problem of interest, and, in the chapters which follow, these deviations will, unless otherwise Edition: current; Page: [ 46 ] specified, be disregarded. The reader may, therefore, in this theoretical study keep to the hypothesis that the monetary unit remains unchanged in purchasing power, with the result that the money rate of interest and the real rate coincide.

That is to say, the rate of interest is assumed to be at once the premium on this year's money in terms of next year's and the same premium on this year's real income in terms of next year's. This premium, that is, the terms of exchange of this year's income and next year's, may be said to depend, in brief, on the relative supply and demand of those two portions of the income stream; and this statement may be interpreted as including almost the entire impatience and investment opportunity theory of this book.

But, like many brief statements, this supply and demand statement is crude and inadequate. Crude and inadequate notions beset this subject and some of them are so common and treacherous that it seems worth while, before proceeding with further analysis, to examine these notions in order to avoid falling into their pitfalls. To say that the rate of interest is fixed by supply and demand is merely to state, not to solve the problem.

The real problem is to analyze the particular supply and demand forces operative in determining the rate of interest. Nor are we greatly enlightened by saying that in one sense the rate of interest is the price of money. For it is Edition: current; Page: [ 47 ] equally true, in another sense, that the purchasing power of money is the price of money.

Yet the rate of interest and the purchasing power of money are two very different things. Nor is it very illuminating to say that the rate of interest is the price paid for the use of money, especially as the money whose use is purchased is usually not money at all but credit—nor is either the money or credit literally used continuously during the loan. It disappears at the beginning and reappears at the end. Enough has already been said to show that an increase in the quantity of money in circulation tends to raise the price level and consequently to depreciate the value of the money unit. This depreciation in turn tends to increase the rate of interest.

Yet, there is a very persistent belief that an increase or decrease in the quantity of money in circulation causes a decrease or increase in the rate of interest. This fallacy seems to be based on a confused interpretation of the general observation that the rate of interest generally rises or falls with a decrease or increase in the reserve ratio of banks. While it is true that if new money first finds its way from the mint into the banks, it tends to lower the rate of interest, this effect is temporary.

The Theory of Interest: As Determined by Impatience to Spend Income and Opportunity Ot Invest It

The maladjustment between the money in banks and in circulation is soon corrected as the demand for loans overtakes the supply. As far as the total supply of money is concerned, if this is doubled in amount and prices are thereby, in the end, doubled too, there is double the money to lend, but borrowers will require double the amount of money.

At the doubled prices they will need twice the money to make the same purchases. The demand is doubled along with the supply and the interest rate remains as before. Another very persistent idea is that to take interest is, necessarily and always, to take an unfair advantage of the debtor. This notion is something more than the obviously true idea that the rate of interest, like any other price, may be exorbitant.

The contention is that there ought to be no interest at all. Throughout history this thought recurs. It seems natural that only what was borrowed should be returned. Why any addition? Interest is therefore called unnatural. The Mosaic law forbade interest taking between Jews, and, similarly in Rome, interest taking between Romans was prohibited.

Many biblical texts show the hostile attitude of the writers, in both the Old and New Testaments, toward the practice. The Church Fathers, through the Middle Ages for over a thousand years, waged a ceaseless but fruitless war against interest taking. Thomas Aquinas stated that interest was an attempt to extort a price for the use of things which had already been used up, as, for instance, grain and wine. He also declared that interest constituted a " payment for time, " and that no such payment could be justified since time was a free gift of the Creator to which all have a natural right.

In fact, interest taking is often prohibited in primitive societies. Loans under primitive conditions are generally made for consumption rather than for productive purposes. Industry and trade being almost unknown, the demand for loans in such communities usually betokens Edition: current; Page: [ 49 ] the personal distress of the borrowers. The loan negotiations take place between two persons under isolated conditions without a regular market. The protection which a modern loan market affords against extortionate prices is absent.

Thus, there is, in many cases, a sound ethical basis for the complaints against interest. But experience shows that complete prohibition of interest cannot be made effective. Interest, if not explicitly, will implicitly persist, despite all legal prohibitions. It lurks in all purchases and sales and is an inextricable part of all contracts. Today the chief survival of the exploitation idea is among Marxian Socialists. These assert that the capitalist exploits the laborer by paying him for only part of what he produces, withholding a portion of the product of labor as interest on capital.

Interest is therefore condemned as robbery. The capitalist is described as one who unjustly reaps what the laborer has sown. The socialist exploitation theory of interest consists virtually of two propositions: first, that the value of any product, when completed, usually exceeds the cost of production incurred during the processes of its production; and secondly, that the value of any product, when completed, "ought" to be exactly equal to that cost of production. The first of these propositions is true, but the second is false; or, at any rate, it is an ethical judgment Edition: current; Page: [ 50 ] masquerading as a scientific economic fact.

Economists, strange to say, in offering answers to the socialists, have often attacked the first proposition instead of the second. The socialist is quite right in his contention that the value of the product does exceed the cost. There is no necessity that the value of a product must equal the costs of production. On the contrary, it never can normally be so. In attempting to prove that the laborer should receive the whole product, the socialist stands on stronger ground than has sometimes been admitted by overzealous defenders of the capitalist system.

The socialist cannot be answered offhand simply by asserting that capital aids labor, and that the capitalist who owns a plow earns the interest payment for its use quite as truly as the laborer operating the plow earns his wages by his labor. For the socialist carries the argument back a stage earlier, and contends that the payment for the use of the plow should belong, not to the capitalist who owns it, but to the laborers who originally made it, including those who made the machinery which helped to make it. He is quite correct in his contention that the value of the uses of the plow is attributable to those who made it, and that, nevertheless, the capitalist, who now owns it, not the laborers who made it in the past, enjoys the value of these uses.

The capitalist is, in a sense, always living on the product of past labor. An investor who gets his income from railroads, ships, or factories, all of which are products of labor, is reaping what past labor has sown. Edition: current; Page: [ 51 ] But the investor is not, as a necessary consequence, a robber. He has bought and paid for the right, economic and moral as well as legal, to enjoy the product ascribable to the capital goods he owns.

The workers' wages, under free competition, constitute payment in full for what they had produced at the time their wages were paid. The answer is: He may receive it, provided he will wait for it 25 years. As Bohm-Bawerk says: But Rodbertus and the Socialists expound it as if it means that the laborer should now receive the entire future value of his product. Socialists would cease to think of interest as extortion if they would try the experiment of sending a colony of laborers into the unreclaimed lands of the West, letting them develop and irrigate those lands and build railways on them, unaided by borrowed capital.

The colonists would find that interest had not disappeared by any means, but that by waiting they had themselves reaped the benefit of it. Let us say they waited five years before their lands were irrigated and their railway completed. At the end of that time they would own every cent of the earnings of both, and no capitalist could be accused of robbing them of it.

But they would find that, in spite of themselves, they had now become capitalists, and that Edition: current; Page: [ 52 ] they had become so by stinting for those five years, instead of receiving in advance, in the shape of food, clothing, and other real income, the discounted value of the railroad. This example was almost literally realized in the case of the Mormon settlement in Utah. Those who went there originally possessed little capital, and they did not pay interest for the use of the capital of others. They created their own capital and passed from the category of laborers to that of capitalists.

It will be seen, then, that capitalists are not, as such, robbers of labor, but are labor-brokers who buy work at one time and sell its products at another. Their profit or gain on the transaction, if risk be disregarded, is interest, a compensation for waiting during the time elapsing between the payment to labor and the income received by the capitalist from the sale of the product of labor.

Despite the persistence of the idea that interest is something unnatural and indefensible, despite the opposition to it by socialists and others who rebel against the existing economic system, despite all attempts to prohibit interest taking, there is not and never has been in all recorded history any time or place without the existence of interest. Several centuries ago, as business operations increased in importance, certain exemptions and exceptions from the ineffectual prohibition of interest were secured.

Pawn-shops, banks, and money-lenders were licensed, and the purchase of annuities and the taking of land on mortgage for money loaned were made legitimate by subterfuge. One of the subterfuges by which the taking of interest Edition: current; Page: [ 53 ] was excused suggests the true idea of interest as an index of impatience. It was conceded that, although a loan should be professedly without interest, yet when the debtor delayed payment, he should be fined for his delay mora , and the creditor should receive compensation in the form of interesse.

Through this loophole it became common to make an understanding in advance by which the payment of a loan was to be delayed year after year, and with every such postponement a fine was to become payable. Some of the Protestant reformers, while not denying that interest taking was wrong, admitted that it was impossible to suppress it, and proposed that it should therefore be tolerated.

This toleration was in the same spirit as that in which many reformers today defend the licensing of vicious institutions, such as saloons, gambling establishments, and houses of prostitution. Today interest taking is accepted as a matter of course except among Marxian socialists and a few others. But the persistent notion that, fundamentally, interest is unjustified has given the subject a peculiar fascination.

It has been, and still is, the great economic riddle. When the rate of interest is 5 per cent, nothing at first thought seems more plausible than that this rate obtains because capital goods will yield 5 per cent in kind.

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It is alleged that because fruit trees bear apples or peaches, and because a bushel of wheat sown has the power to multiply into 50 bushels, and because a herd of cattle Edition: current; Page: [ 54 ] if unmolested may double in numbers every two years interest is therefore inherent in nature. As a matter of fact, this productivity, as we shall see, is a real element in the explanation of interest; but it is not the only one nor is it as simple as it seems. In some degree, the theory elaborated in this book is a productivity theory.

This theory, or fallacy, is not espoused by any careful student of the interest problem, but it exists in the minds of many before they begin to analyse the problem. It confuses physical productivity 26 with value return. Following the principles of Chapter I, we may take, as an illustration, an orchard of ten acres yielding barrels of apples a year. The physical productivity, barrels per acre per year, does not of itself give any clue to what rate of return on its value the orchard yields. To obtain the value return on the orchard, we must reduce both physical income and capital goods the farm to a common standard of value.

But how can we thus pass from heterogeneous quantities to homogeneous values? How can we translate the ten acres of orchard and the barrels of apples into a common standard—dollars? May not this apparently simple step beg the whole question? The statement that "capital produces income" is true only in the physical sense; it is not true in the value sense.

That is to say, capital value does not produce income value. On the contrary, income value produces capital value. In short, we are forced back to the confession that when we are dealing with the values of capital and income, their causal connection is the reverse of that which holds true when we are dealing with their quantities. The orchard is the source of the apples; but the value of the apples is the source of the value of the orchard. In the same way, a dwelling is the source of the shelter it yields; but the value of that shelter is the source of the value of the dwelling. In the same way a machine, a factory, or any other species of capital instrument is the source of the services it renders but the value of these services is the source of the value of the instrument which renders them.

This principle is complicated, but not impaired, by the fact that the cost of production of further dwellings, machines, tools, and other capital plays a part. The principle which rests on future incomes, including, of course, items of negative future income costs applies to any existing capital at any stage of its existence. The value of anything as indicated in Chapter I, and more fully in The Nature of Capital and Income is typified by the case of a bond whose value, as every broker knows, is calculated solely from the future services, or sums, expected and the rate of interest and the risk.

The cost of producing other competing houses or other instruments so valued, in so far as that cost lies in the future, has an important influence. Past costs may also affect the value of the house by influencing through competition the value of the future services or disservices of that house, or the rate of interest, or the risk. Although business men are constantly employing this discounting process in the valuation of every specific item of property bought or sold, they often cherish the illusion that somehow, somewhere, there is capital which does not get its value by discounting future services but has already made value which produces interest.

They persist in thinking of interest as moving forward in time instead of as discount moving backward. The necessity of presupposing a rate of interest is re-inforced by observing the effect of a change of the rate of productivity. If an orchard could in some sudden and wholly unexpected way be made to yield double its original crop per acre, only its yield in the sense of physical productivity would be doubled; its yield in the sense of the rate of interest would not necessarily be affected at Edition: current; Page: [ 57 ] all, certainly not doubled, 27 because the value of the orchard would automatically advance with an increase in its value productivity.

The rate of physical productivity is evidently not the rate of interest. The rate of physical productivity is not ordinarily even the same kind of magnitude as the rate of interest. Bushels of wheat produced per acre is an entirely different sort of ratio from the rate per cent of the net value of the yield of land relative to the value of the land. Interest is a rate per cent, an abstract number. Physical productivity is a rate of one concrete thing relatively to another concrete thing incommensurable with the first.

In this chapter I have tried at least to mention, if not completely to remove in advance, the chief pitfalls or impediments to the understanding of the interest problem. Two other pitfalls, discussed elsewhere, may be here mentioned so that the reader may be on his guard against them also. One is the idea that interest is a cost. While an interest payment, like any other payment, is a cost or outgo to the payer, it is income to the payee.

But interest itself, as it accrues, is capital gain; and is neither negative income cost nor positive income. The fallacious idea that it is a cost is simply the other side of the fallacious idea, discussed in Chapter I, that it is income. There are two Edition: current; Page: [ 58 ] kinds of economic gain, capital gain and income gain, the former being the anticipation or discounted value of the latter. Interest is the former kind. It gradually accrues, along a discount curve as the income which it anticipates grows nearer.

But it is not itself income, nor is it cost. The other pitfall is the idea that interest is a certain part of the income stream of society, the part namely which goes to capital, the other parts being rent, wages, and profits. I shall, in Chapter XV, discuss the relation of interest to the whole problem of the distribution of wealth. But it may help if the reader is again warned at this point, as he has already been warned in Chapter I, against the idea that any one part of the income stream has an exclusive relation to the rate of interest.

All income is subject to discount, or capitalization, that from land as well as that from other capital goods. And if the whole income stream of society, including all wages, all rents and all profits were capitalized, that whole income could still be regarded as a rate per cent, i.

IN the preceding chapter we mentioned some pitfalls in the explanation of interest. We are now ready to consider more searchingly the fundamental causes which determine the rate of interest. We shall find a place for each of the partial truths contained in the inadequate theories. Many people think of interest as dependent directly on capital. As already suggested, it will help the reader to proceed in the following analysis if he will try to forget capital and instead think exclusively of income. Capital wealth is merely the means to the end called income, while capital value which is the sense in which the term capital is ordinarily used by interest theorists is merely the capitalization of expected income.

The theory of interest bears a close resemblance to the theory of prices, of which, in fact, it is a special aspect. The rate of interest expresses a price in the exchange between present and future goods. Just as, in the ordinary theory of prices, the ratio of exchange of any two articles is based, in part, on a psychological or subjective element—their comparative marginal desirability—so, in the theory of interest, the rate of interest, or the premium on the exchange between present and future goods, is based, in part, on a subjective element, a derivative of marginal Edition: current; Page: [ 62 ] desirability; namely, the marginal preference for present over future goods.

This preference has been called time preference, or human impatience. The chief other part is an objective element, investment opportunity. It is the impatience factor which we shall now discuss, leaving the investment opportunity factor for discussion in later chapters.


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Thus the rate of time preference, or degree of impatience, for present over future goods of like kind is readily derived from the marginal desirabilities of, or wants for, those present and future goods respectively. What are these goods which are thus contrasted? At first sight it might seem that the goods compared may be indiscriminately wealth, property, or services. It is true that present machines are in general preferred to future machines; present houses to future houses; land possessed today to land available next year; present food or clothing to future food or clothing; present stocks or bonds to future stocks or bonds; present music to future music, and so on.

But a slight examination will show that some of these cases of preference are reducible to others. When present capital wealth, or capital property, is preferred to future, this preference is really a preference for the income expected to flow from the first capital wealth, or capital property, as compared with the income from the second. The reason why we would choose a present fruit tree rather than a similar tree available in ten years is that the fruit yielded by the first will come earlier than the fruit yielded by the second.

The reason one prefers immediate tenancy of a house to the right to occupy it in six months is that the uses of the house under the first leasehold begin six months earlier than under the second. In short, capital wealth, or capital property, available early is preferred to the capital wealth, or capital property of like kind, available at a more remote time simply and solely because the income from the former is available earlier than the income from the latter. Thus all time preference resolves itself in the end into the preference for comparatively early income over comparatively remote, or deferred, income.

Moreover, the Edition: current; Page: [ 64 ] preference for early, or prompt, income over late, or deferred, income resolves itself into the preference for early enjoyment income over deferred enjoyment income. Any income item which consists merely of an interaction or, otherwise expressed, of a preparatory service 31 that is, an item which, while it is income from one species of capital, is outgo in respect to another species is wanted for the sake of the enjoyment income to which that interaction paves the way. The consumer prefers the service of milling flour in the present to milling flour in the future because the enjoyment of the resulting bread is available earlier in the one case than in the other.

The manufacturer prefers present weaving to future weaving because the earlier the weaving takes place the sooner will he be able to sell the cloth and realize his enjoyment income. To him, early sales are more advantageous than deferred sales, not because he desires the cloth to reach its ultimate destination sooner, but because he will the sooner be in a position to make use of the purchase price for his own personal uses—the shelter and comforts of various kinds constituting his income. The manufacturer is conscious of only one step toward the ultimate goal of clothes—the money he expects to get for the cloth from the jobber to whom he sells it.

But this money payment in turn discounts a further step. To the jobber this money he pays is the discounted value of the money he will receive from the wholesaler, and so on through the retailer, tailor and wearer. The result is that each is unconsciously discounting, as the ultimate link in the chain, the enjoyment to be derived by the wearer of the clothes. Of course this is not the whole Edition: current; Page: [ 65 ] story, but it represents the main parts relevant to the present problem. All preference, therefore, for present over future goods resolves itself, in the last analysis, into a preference for early enjoyment income over deferred enjoyment income.

This simple proposition would have received definite attention earlier in the history of economics had there been at hand a clear-cut concept of income. But, as explained in Chapter I, for practical purposes we may well stop at the objective services of wealth, as measured by its cost—the cost of living—that is, the money values of nourishment, clothing, shelter, amusements, the gratifications of vanity, and the other miscellaneous items in our family budget.

It is the money value of this income stream upon which attention now centers. Henceforth, we may think of time preference as the preference for a dollar's worth of early real income over a dollar's worth of deferred real income. It is assumed, then, that the income goods are reduced to a common money denominator, and that the prices of all items of real income—the prices of nourishment, shelter, clothing, amusements, etc. In these cases, as already noted, no appreciable time elapses between valuation and realization. We pay for a basket of fruit and eat it forthwith.

But we pay for a fruit tree and wait years for the fruit. So in the prices of many other enjoyable services—nourishment, shelter, etc. When, however, any goods other than enjoyable goods are considered, their values already contain a rate of interest. The price of a house is the discounted value of its future income. Hence, when we compare the values of present and future houses, both terms of the comparison already involve a rate of interest. Although, as will be noted more specifically later, such a complication would not necessarily beg the question, its elimination simplifies the picture.

Time preference, a concept which psychologically underlies interest, lends itself to express any situation, either preference for present as against future goods or preference for future as against present goods or for no preference. The term impatience carries with it the presumption that present goods are preferred. But I shall treat the two terms impatience and time preference as synonymous. Henceforth the term impatience will be the one chiefly used partly because its meaning is more self-evident, partly because it is shorter, and partly because it does carry a presumption as to the usual direction of the time preference.

The degree of impatience varies, of course, with the individual, but when we have selected our individual, the degree of his impatience depends on his entire income stream, beginning at the present instant and stretching indefinitely into the future; that is, Edition: current; Page: [ 67 ] on the amount of his expected real income and the manner in which it is expected to be distributed in time. It depends in particular on the relative abundance of the early as compared with the remote income items—or what we shall call the time shape of the expected income stream.

If income is particularly abundant in the future; that is, if the person expects an increase in his income stream, he would willingly promise to sacrifice out of that increase, when it comes, a relatively large sum for the sake of receiving a relatively small sum at once. Thus the possessor of a strawberry patch might, in winter, be willing to exchange two boxes of strawberries, due in six months, for one available today.

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On the other hand, if immediate income is abundant but future income scarce, the opposite relation may exist. In strawberry season, the same man might willingly give up two boxes of his then abundant crop for the right to only one box in the succeeding winter. That is, time preference may not always be a preference for present over future goods; it may, under certain conditions, be the opposite.

Impatience may be and sometimes is negative! It is, therefore, not necessary in beginning our study of interest to distinguish, as many writers do, between the principles which lead to the existence of interest and those which regulate the rate of interest. By the existence of interest these writers mean that the rate is greater than zero. It seems preferable to reverse the order of the two problems and seek first to find the principles which fix the terms on which present and future goods exchange, without restricting ourselves in advance to the thesis that, always and necessarily, present goods command a premium over future goods.

If our principles permit the deviations from par to be in either direction, this Edition: current; Page: [ 68 ] will mean that the rate of interest may under certain circumstances be zero i. After these general principles have been established a special study will then be in order to discover why the rate of interest is, in actual experience, almost never zero or negative. We noted, in Chapter II, that when gold, or any other durable commodity capable of being stored or kept without cost, is the standard of comparison, the rate of interest in terms of that standard cannot fall below zero.

Does the reason why interest is, in general experience, positive rather than negative lie entirely in human nature? Or does it lie partly in the income stream? These special questions can best be answered after we have found the general principles by which the rate of interest, be it positive, negative, or zero, is determined. The preference of any individual for early over deferred income depends upon his present as compared with his prospective income and corresponds to the ordinary theory of prices, which recognizes that the marginal want for any article depends upon the quantity of that article available.

Both propositions are fundamental in their respective spheres. The relationship of these problems, and others, may be schematized roughly as shown in Chart 4 which follows. In this chart A and B represent present prices of enjoyable goods; and A ' and B ' prices of future enjoyable goods. A and A ' refer to different years in the same place, say New York; B and B ' are similar except that they relate to a different place, say London.

All problems of local prices, exchange, and interest, act and react on each other in many ways. The problem of "time" foreign exchange, or forward foreign exchange, is indicated by the diagonals, and involves both interest and foreign exchange, i. Both exchange and interest rates, as well as local prices, would be, theoretically, combined if, say, present New York wheat were quoted in terms of future London coal.

In this book, for simplicity, the problems of price determinations, in one place and at one time, are supposed to have been solved. Likewise we neglect the problem of foreign exchange; we are studying only the problem of interest. In the above schematic picture only two periods of time are represented. In actual life there are many periods—an indefinite number of them.

Theoretically there might be a rate of interest connecting every pair of possible dates. For instance, there might be a rate of interest between the present and one year hence, another between one year hence and two years hence, and so on, all these rates being quotable in today's markets. In practice no rates are actually quoted except those connecting the present which, of course, merely means a future date near the present with several more remotely future dates.

A rate on a five year contract may be considered as a sort of an average of five theoretically existing rates, one for each of the five years covered. Except when the contrary is specifically mentioned, it will henceforth be understood, for the sake of simplicity, that there is only one rate of interest, the rate of interest, applicable to all time intervals. This may be most conveniently pictured to mean the rate connecting today with one year hence. Even this rate of interest connecting two specific dates separated by one year depends on or, in technical terminology, is a function of conditions not only at these two dates but at many other dates.

If we wish to be still more meticulous, we may note that a person's income stream is made up of a large number of different elements, filaments, strands, or fibers, some of which represent nourishment, others shelter, others amusement, and so on—all the components of real income.

In a complete enumeration of these elements, we should need to distinguish the use of each different kind of food, and the gratification of every other variety of human want. Each of these constitutes a particular thread of the income stream, extending out from the present into the indefinite future, and varying at different points of time in respect to size and probability of attainment.

A person's time preference, or impatience for income, therefore, depends theoretically on the size, time shape, and probability as looked at in the present of this entire collection of income elements as we may picture them stretching out into the entire future. In summary, we may say then that an individual's impatience depends on the following four characteristics of his income stream:. Our first step, then, is to show how a person's impatience depends on the size of his income, assuming the other three conditions to remain constant; for, evidently, it is possible that two incomes may have the same time shape, composition and risk, and yet differ in size, one being, say, twice the other in every period of time.

In general, it may be said that, other things being equal, the smaller the income, the higher the preference for present over future income; that is, the greater the impatience to acquire income as early as possible. It is true, of course, that a permanently small income implies a keen appreciation of future wants as well as of immediate wants.

Poverty bears down heavily on all portions of a man's expected life. But it increases the want for immediate income even more than it increases the want for future income.

Evaluating the Liquidity Premium Theory

This influence of poverty is partly rational, because of the importance, by supplying present needs, of keeping up the continuity of life and thus maintaining the ability to cope with the future; and partly irrational, because the pressure of present needs blinds a person to the needs of the future.

As to the rational aspect, present income is absolutely indispensable, not only for present needs, but even as a pre-condition to the attainment of future income. A man must live. Any one who values his life would, under ordinary circumstances, prefer to rob the future for the benefit of the present—so far, at least, as to keep life going.

If a person has only one loaf of bread he would not set it aside for next year even if the rate of interest were per cent; for if he did so, he would starve in Edition: current; Page: [ 73 ] the meantime. A single break in the thread of life suffices to cut off all the future. We stress the importance of the present because the present is the gateway to the future.

Understanding the Yield Curve

Not only is a certain minimum of present income necessary to prevent starvation, but the nearer this minimum is approached the more precious does present income appear relative to future income. As to the irrational aspect of the matter, the effect of poverty is often to relax foresight and self-control and to tempt us to "trust to luck" for the future, if only the all-engrossing need of present necessities can be satisfied.

Evaluating the Liquidity Premium Theory

We see, then, that a small income, other things being equal, tends to produce a high rate of impatience, partly from the thought that provision for the present is necessary both for the present itself and for the future as well, and partly from lack of foresight and self-control. It considers and explains the supply of capital as the outcome of savings alone.

It does not recognise the impact of the banking system and credit creation by commercial banks on investments and the rate of Interest. Economists like Erich Roll and others have stated that the very existence of time-preference is questionable and even if it exists, it is very difficult to see any precise significance of time-preference on the determination of Interest.

To some critics, it is not proper or it is incorrect to say that a person always prefers present consumption to the future one so that he always insist on a premium to be paid for postponement. On the contrary, strangely enough, very often a person is found to have realised greater satisfaction from future consumption than the present one.

Therefore, with these arguments economists do not call this theory as a correct principle of Interest determination. This theory was expounded by eminent economists like Prof. Pigou, Prof. Marshall, Walras, Knight etc. According to this theory, Interest is the reward for the productive use of the capital which is equal to the marginal productivity of physical capital.

The supply of capital is governed by the time preference and the demand for capital by the expected productivity of capital. Both time preference and productivity of capital depend upon waiting or saving. The theory is, therefore, also known as the supply and demand theory of waiting or saving. Demand for capital implies the demand for savings. Investors agree to pay interest on these savings because the capital projects which will be undertaken with the use of these funds, will be so productive that the returns on investment realised will be in excess of the cost of borrowing, i.

In short, capital is demanded because it is productive, i. The marginal productivity curve of capital thus determines the demand curve for capital. This curve after a point is a downward sloping curve. While deciding about an investment, the entrepreneur, however, compares the marginal productivity of capital with the prevailing market rate of Interest. When, the rate of Interest falls, the entrepreneur will be induced to invest more till marginal productivity of capital is equal to the rate of Interest. Thus, the investment demand expands when the Interest rate falls and it contracts when the Interest rate rises.

As such, investment demand is regarded as the inverse function of the rate of Interest. Supply of capital depends basically on the availability of savings in the economy. To some classical economists like Senior, abstinence from consumption is essential for the act of saving while economists like Fisher. Stress that time preference is the basic consideration of the people who save. In both the views the rate of Interest plays an important role in the determination of savings.

The chemical economists commonly hold that the rate of saving is the direct function of the rate of Interest. That is, savings expand with the rise in the rate of Interest and when the rate of Interest falls, savings contract. It must be noted that the saving-function or the supply of savings curve is an upward-sloping curve. The equilibrium rate of Interest is determined at that point at which both demand for and supply of capital are equal.

In other words, at the point at which investment equals savings, the equilibrium rate of Interest is determined. In the figure given here OR is the equilibrium rate of Interest which is determined at the point at which the supply of savings curve intersects the investment demand curve, so that OQ amount of savings is supplied as well as invested.

Indeed, the demand for capital is influenced by the productivity of capital and the supply of capital. In turn savings are conditioned by the thrift habits of the community. Thus, the classical theory of Interest implies that the real factor, thrift and productivity in the economy are the fundamental determinants of the rate of Interest.

The theory of Interest of the classical economists has been severely criticised by Keynes and others. According to Keynes—Interest is purely a money phenomenon, a payment for the use of money and that the rate of Interest is a reward for parting with liquid cash i. It completely neglects the influence of monetary factors on the determination of the rate of Interest.

They failed to take into account money as a store of value. Keynes has said that the classical theory of Interest is confusing and indeterminate. We cannot know the rate of Interest unless we know the savings and investment schedules which again, cannot be known unless the rate of Interest is known.

Thus, it can be said that the theory fails to offer a determinate solution. Because it assumes that income not spend on consumption should necessarily be diverted to investment, it ignores the possibility of saving being hoarded. It fails to integrate monetary theory into the general body of economic theory. Classicists have described the rate of interest as an equilibrating factor between savings and investment:.

It is the price which equilibrates the desire to hold wealth in the form of cash. Because it ignores consumption loans and takes into account only the capital used for productive purposes. Keynes differs with the classical economists even over the very definition and determination of the rate of interest:. Keynes has said that Interest is the reward of parting with liquidity for a specified period.

He does not agree that Interest is determined by the demand for and supply of capital. With these arguments Keynes has completely dismissed the classical theory of Interest as absolutely wrong and inadequate. He has never been agreeable with the view of classists. Further, this theory was elaborated by Ohlin, Roberson, Pigou and other new-classical economists. This theory is an attempt to improve upon the classical theory of Interest. According to this theory, the rate of Interest is the price of credit which is determined by the demand and supply for loanable funds.

The Government borrows funds for constructing public works or for war preparations or for public consumption to maintain law and order, administration, justice, education, health, entertainment etc. To compensate deficit budget during depression or to invest in and for other development purposes.

Generally government demand for loanable funds is not affected by the Interest rate. The businessmen borrow for the purchase of capital goods and for starting investment projects. The businessmen or firms require different types of capital goods in order to run or expand their production. If the businessmen do not possess sufficient money to purchase these capital goods, they take loans. Businessmen investment demand for loanable funds depends on the quantity of their production. It means there will be less demand on higher Interest and more demand on lower Interest.

The consumers take loans for consumption purposes. They prefer present consumption, they wish to purchase more consumption, goods than their present income allows and for that they take loans. They take loans to purchase mainly two types of consumption goods. First, durable consumption goods and secondly to purchase consumption goods of daily use and they generally open their accounts with the seller and go on purchasing goods on credit basis.

Besides these they take loans for investment or speculative purposes also. Behind this they have profit motive. The supply of loanable funds comes from savings, dis-hoardings and bank credit. Private savings, individual and corporate are the main source of savings.


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  6. Though personal savings depend upon the income level, yet taking the level of income as given, they are regarded as Interest elastic. The higher the rate of Interest, the greater will be the inducement to save and vice-versa. There is a positive relationship between Interest-rate and the supply of loanable funds. It means there will be more supply of loanable funds at higher interest and less supply on lower interest.

    Hence the supply curve of loanable funds will be an upward sloping curve from left to right. The equilibrium between the demand for and supply of loanable funds or the intersection between demand and supply curves of loanable funds indicates the determination of the market rate of interest. It has been shown in the diagram given here. In the diagram demand curve for loanable funds DL and supply curve of loanable funds SL meet at point E.

    Therefore, E will be the equilibrium point and OR will be the equilibrium rate of interest. At this rate of interest demand for and supply of loanable funds both are equal to OL. Given the supply of loanable funds, if the demand for loanable funds rises, the Interest rate will also rise and if the demand for loanable funds falls, the Interest rate will also fall. Similarly, given the demand for loanable funds, Interest rate will rise with the fall in the supply of loanable funds and will fall with the rise in the supply of loanable funds. Because according to this theory Interest rate determination depends on savings.

    But saving depends on income, income depends on investment and investment itself depends on Interest rate. In this theory the equilibrium between demand for and supply of loanable funds cannot be brought by the changes in interest rate:. Investment in the demand for loanable funds and savings in the supply of loanable funds are important elements. Both saving and investment are not so much influenced by Interest as they are influenced by the changes in income-levels.