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6. Production: The Rate of Interest and Its Determination

6. The Post-Income Demanders

Up to this point we have analyzed the time-market demand for present goods by landowners and laborers, as well as the derived demand by capitalists. This aggregate demand we may call the producers’ demand for present goods on the time market. This is the demand by those who are selling their services or the services of their owned property in the advancing of production. This demand is all pre-income demand as we have defined it; i.e., it takes place prior to the acquisition of money income from the productive system. It is all in the form of selling factor services (future goods) in exchange for present money. But there is another component of net demand for present goods on the time market. This is the post-income component; it is a demand that takes place even after productive income is acquired. Clearly, this demand cannot be a productive demand, since owners of future goods used in production exercise that demand prior to their sale. It is, on the contrary, a consumers’ demand.

This subdivision of the time market operates as follows: Jones sells 100 ounces of future money (say, one year from now) to Smith in exchange for 95 ounces of present money. This future money is not in the form of an expectation created by a factor of production; instead, it is an I.O.U. by Jones promising to pay 100 ounces of money at a point one year in the future. He exchanges this claim on future money for present money—95 ounces. The discount on future money as compared with present money is precisely equivalent to that in the other parts of the time market that we have studied heretofore, except that the present case is more obvious. The rate of interest finally set on the market is determined by the aggregate net supply and net demand schedules throughout the entire time market, and these, as we have seen, are determined by the time preferences of all the individuals on the market. Thus, in the case of Figure 50 above, in diagram III we have a case of a net (post-income) demander at the market rate of interest The form that his demand takes is the sale of an I.O.U. of future money—usually termed the “borrowing” of present money. On the other hand, the person whose time-market curve is shown in diagram IV has such a time-preference configuration that he is neither a net supplier nor a net demander at the going rate of interest—he is not on the time market at all—in his post-income position.

The net borrowers, then, are people who have relatively higher time-preference rates than others at the going rate of interest, in fact so high that they will borrow certain amounts at this rate. It must be emphasized here that we are dealing only with consumption borrowing—borrowing to add to the present use of Jones’ money stock for consumption. Jones’ sale of future money differs from the sales of the landowners and laborers in another respect; their transactions are completed, while Jones has not yet completed his. His I.O.U. establishes a claim to future money on the part of the buyer (or “lender”) Smith, and Smith, to complete his transaction and earn his interest payment, must present his note at the later date and claim the money due.

In sum, the time market's components are as follows:

These demands are aggregated without regard to whether they are post- or pre-income; they both occur within a relatively brief time period, and they recur continually in the ERE.

Although the consumption and the productive demands are aggregated to set the market rate of interest, a point of great importance for the productive system is revealed if we separate these demands analytically. The diagram in Figure 51 depicts the establishment of the rate of interest on the time market.

The vertical axis is the rate of interest; the horizontal axis is gold ounces. The SS curve is the supply-of-savings schedule, determined by individual time preferences. The CC curve is the schedule of consumers’ loan demands for present goods, consisting of the aggregate net demand (post-income) at the various hypothetical rates of interest. The DD curve is the total demand for present goods by suppliers of future goods, and it consists of the CC curve plus a curve that is not shown—the demand for present goods by the owners of original productive factors, i.e., land and labor. Both the CC and the DD curves are determined by individual time preferences. The equilibrium rate of interest will be set by the market at the point of intersection of the SS and DD curves—point E.

The point of intersection at E determines two important resultants: the rate of interest, which is established at 0A, and the total supply of savings AE. A vital matter for the productive system, however, is the position of the CC curve: the larger CC is at any given rate of interest, the larger the amount of total savings that will be competed for and drawn away from production into consumers’ loans. In our diagram, the total savings going into investment in production is BE.

The relative strength of productive and consumption demand for present goods in the society depends on the configurations of the time-preference schedules of the various individuals on the market. We have seen that the productive demand for present goods tends to be inelastic with respect to interest rates; on the other hand, the consumers’ loan curve will probably display greater elasticity. It follows that, on the demand side, changes in time preferences will display themselves mostly in the consumption demand schedule. On the supply side, of course, a rise in time preferences will lead to a shift of the SS curve to the left, with less being saved and invested at each rate of interest. The effects of time-preference changes on the rate of interest and the structure of production will be discussed further below.

It is clear that the gross savings that maintain the production structure are the “productive” savings, i.e., those that go into productive investment, and that these exclude the “consumption” savings that go into consumer lending. From the point of view of the production system, we may regard borrowing by a consumer as dissaving, for this is the amount by which a person's consumption expenditures exceed his income, as contrasted to savings, the amount by which a person's income exceeds his consumption. In that case, the savings loaned are canceled out, so to speak, by the dissavings of the consumption borrowers.

The consumers’ and producers’ subdivisions of the time market are a good illustration of how the rate of interest is equalized over the market. The connection between the returns on investment and money loans to consumers is not an obvious one. But it is clear from our discussion that both are parts of one time market. It should also be clear that there can be no long-run deviation of the rate of interest on the consumption loan market from the rate of interest return on productive investment. Both are aspects of one time market. If the rate of interest on consumers’ loans, for example, were higher than the rate of interest return from investment, savings would shift from buying future goods in the form of factors to the more remunerative purchase of I.O.U.'s. This shift would cause the price of future factors to fall, i.e., the interest rate in investment to rise; and the rate of interest on consumers’ loans to fall, as a result of the competition of more savings in the consumer loan arena. The everyday arbitrage of the market, then, will tend to equalize the rate of interest in both parts of the market. Thus, the rate of interest will tend to be equalized for all areas of the economy, as it were in three dimensions—”horizontally” in every process of production, “vertically” at every stage of production, and “in depth,” in the consumer loan market as well as in the production structure.

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