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11. Money and Its Purchasing Power > 5. The Demand for Money

## G. The Purchasing-Power and Terms-of-Trade Compenents in the Rate of Interest

Many economists, beginning with Irving Fisher, have asserted that the market rate of interest, in addition to containing specific entrepreneurial components superimposed on the pure rate of interest, also contains a “price” or a “purchasing-power component.” When the purchasing power of money is generally expected to rise, the theory asserts that the market rate of interest falls correspondingly; when the PPM is expected to fall, the theory declares that the market rate of interest rises correspondingly.

These economists erred by concentrating on the *loan rate* rather than on the natural rate (the rate of return). The reasoning behind this theory was as follows: If the purchasing power of money is expected to change, then the pure rate of interest (determined by time preference) will no longer be the same in “real terms.” Suppose that 100 gold ounces exchange for 105 gold ounces a year from now—i.e., that the rate of interest is 5 percent. Now, suddenly, let there be a general expectation that the purchasing power of money will increase. In that case, a *lower* amount to be returned, say 102 ounces, may yield 5 percent real interest in terms of purchasing power. A general expectation of a rise in purchasing power, therefore, will lower the market rate of interest at present, while a general expectation of a fall in purchasing power will raise the rate.28

There is a fatal defect in this generally accepted line of reasoning. Suppose, for example, that prices are generally expected to fall by 50 percent in the next year. Would someone lend 100 gold ounces to exchange for 53 ounces one year from now? Why not? This would certainly preserve the real interest rate at 5 percent. But then why should the would-be lenders not simply hold on to their money and *double* their real assets as a result of the price fall? And that is precisely what they would do; they certainly would not give money away, even though their real assets would be greater than before. Fisher simply shrugged off this point by saying that the purchasing-power premium could never make the interest rate negative. But this flaw vitiates the entire theory.

The root of the difficulty consists in ignoring the natural rate of interest. Let us consider the interest rate in those terms. Then, suppose 100 ounces are paid for factors that will be transformed in one year into a product that sells for 105 gold ounces, for an interest gain of five and an interest return of 5 percent. Now a general expectation arises of a general *halving* of prices one year from now. The selling price of the product will be 53 ounces in a year's time. What happens now? Will entrepreneurs buy factors for 100 and sell at 53 merely because their real interest rate is preserved? Certainly not. They will do so only if they do not at all anticipate the change in purchasing power. But to the extent that it *is* anticipated, they will hold money rather than buy factors. This will *immediately* lower factor prices to their expected future levels, say from 100 to 50.

What happens to the *loan rate* is analytically quite trivial. It is simply a reflection of the natural rate and depends on how the expectations and judgment of the people on the loan market compare with those on the stock and other markets. For the free economy, there is no point in separately analyzing the loan market. Analysis of the Fisher problem—the relation of the interest rate to price changes—should concentrate on the *natural* rate of interest. Discussion of the relation between price movements and the (natural) rate of interest should be divided into two parts: first, assuming “neutral money”—that all prices change equally and at the same time—and second, analyzing conditions where factor and product change at different rates. And these changes should first be analyzed without considering that they had been *anticipated* by people on the market.

Suppose, first, that all prices change equally and at the same time. Instead of thinking in terms of 100 ounces borrowed on the loan market, let us consider the natural rate. An investor buys factors in period 1 and then sells the product, say in period 3. Time, as we have seen, is the essence of the production structure. All the processes take time, and capitalists pay money to owners of factors in advance of production and sale. Since factors are bought before products are sold, what is the effect of a period of rising general prices (i.e., falling PPM)? The result is that the entrepreneur reaps an apparent extra profit. Suppose that he normally purchases original factors for 100 and then sells the product for 120 ounces two years later, for an interest return of 10 percent per annum. Now suppose that a decrease in the demand for money or an increase of money stock propels a general upward movement in prices and that all prices double in two years’ time. Then, just because of the passage of time, an entrepreneur who purchases factors for 100 now will sell for 240 ounces in two years’ time. Instead of a net return of 20 ounces, or 10 percent per annum, he reaps 140 ounces, or 70 percent per annum.

It would seem that a rise in prices creates an inherent tendency for large-scale profits that are not simply individual rewards for more accurate forecasting. However, more careful analysis reveals that this is not an extra profit at all. For the 240 ounces two years from now is roughly equivalent, in terms of purchasing power, to 120 ounces now. The *real* rate of net return, based on money's services, is the same 10 percent as it has always been. It is clear that any lower net return would amount to a decline in real return. A return of a mere 120 ounces, for example, would amount to a drastic negative real return, for 100 ounces would then be invested for the equivalent gross return of only 60 ounces. It has often been shown that a period of rising prices misleads businessmen into thinking that their increased money profits are also real gains, whereas they only maintain real rates of return. Consider, for example, “replacement costs”—the prices which the businessmen will *now* have to pay for factors. The capitalist who earns 240 ounces on a 100-ounce investment neglects to his sorrow the fact that his factor bundle now costs 200 ounces instead of 100. Businessmen who under such circumstances treat their monetary profits as real profits and consume them soon find that they are really consuming their capital.

The converse occurs in the case of falling prices. The capitalist buys factors in period 1 and sells the product in period 3, when all-around prices are lower. If prices are to fall by a half in two years, an investment of 100, followed by a sale at 60, does not really involve the terrific loss that it appears to be. For the 60 return is equivalent in real terms, both in generalized purchasing power and in replacement of factors, to 120 previous ounces. His real rate of return remains the same. The consequence is that businessmen will be likely to *overstate their losses* in a period of price contraction. Perhaps this is one of the major reasons for the deep-seated belief of most businessmen that they always gain during a general price expansion and lose during a period of general contraction. This belief is purely illusory.

In these examples, the natural interest rate on the market has contained a *purchasing-power component*, which corrects for real rates, positively in money terms during a general expansion, and negatively during a general contraction. The loan rate will be simply a reflection of what has been happening in the natural rate. So far, the discussion is similar to Fisher's, except that these are the effects of *actual*, not anticipated, changes and the Fisher thesis cannot take account of the negative interest rate case. We have seen that rather than take a monetary loss, even though their real return will be the same, entrepreneurs will hold back their purchases of factors until factor prices fall immediately to their future low level. But this process of anticipatory price movement does not occur only in the extreme case of a prospective “negative” return. *It happens whenever a price change is anticipated.* Thus, suppose all entrepreneurs generally anticipate that prices will double in two years. The fact of an anticipated rise will lead to an increase in the price level *now* and an approach immediately toward a doubled price level. An anticipated fall will lead to an immediate fall in factor prices. If all changes were anticipated by everyone, there would be no room for a purchasing-power component to develop. Prices would simply fall immediately to their future level.

The purchasing-power component, then, is *not* the reflection, as has been thought, of *expectations* of changes in purchasing power. It is the reflection of the change itself; indeed, *if the change were completely anticipated, the purchasing power would change immediately, and there would be no room for a purchasing-power component in the rate of interest*. As it is, partial anticipations speed up the adjustment of the PPM to the changed conditions.

So far we have distinguished three components of the natural rate of interest (all reflected in the loan rate of interest). One is the *pure rate* of interest—the result of individual time preferences, tending to be uniform throughout the economy. Second are the specific entrepreneurial rates of interest. These differ from firm to firm and so are not uniform. They are anticipated in advance, and they are the rates that an investor will have to anticipate receiving before he enters the field. A particularly “risky” venture, if successful at all, will therefore tend to earn more in net return than what is generally anticipated to be a “safe” venture. The third component of the natural rate of interest is the purchasing-power component, correcting for general PPM changes because of the inevitable time lags in production. This will be positive in an expansion and negative in a contraction, but will be ephemeral. The more that changes in the PPM are anticipated, the *less* important will be the purchasing-power component and the more rapid will be the adjustment in the PPM *itself*.

There is still a fourth component in the natural rate of interest. This exists to the extent that money changes are *not* neutral (and they never are). Sometimes product prices rise and fall faster than factor prices, sometimes they rise and fall more slowly, and sometimes their behavior is mixed, with some factor prices and some product prices rising more rapidly. Whenever there *is* a general divergence in rates of movement between the prices of the product and of original factors, a *terms-of-trade* component emerges in the natural rate of interest.

Historically, it has often been the case that product prices rise more rapidly and fall more rapidly than the prices of original factors. In the former case, there is, during the period of transition, a favorable change in the terms of trade to the general run of capitalists. For selling prices are increasing *faster* than the buying prices of original factors. This will increase the general rate of return and constitute a general positive terms-of-trade component in the natural rate of interest. This, of course, will also tend to be reflected in the loan rate of interest. In the case of a contraction, a more sluggish fall in the prices of factors creates a general negative terms-of-trade component in the interest rate. The components are precisely the reverse whenever factor prices change more rapidly than product prices. Whenever there is no general change in the “terms of trade” to capitalist-entrepreneurs, no terms-of-trade component will appear in the interest rate.

Changes in terms of trade discussed here are only those resulting purely from differences in the speed of reaction to changing conditions. They do *not* include basic changes in the terms of trade resulting from changes in time preferences, such as we have discussed above.

It is clear that all the interest-rate components aside from the pure rate—entrepreneurial, purchasing power, and terms of trade—are “dynamic” and the result of uncertainty. None of these components would exist in the ERE, and therefore the market interest rate in the ERE would equal the pure rate determined by time preferences alone. In the ERE the only net incomes would be a uniform pure interest return and wages to labor (ground land rents being capitalized into an interest return).

- 28. Irving Fisher,
*The Rate of Interest*(New York, 1907), chap. v, xiv; idem,*Purchasing Power of Money*, pp. 56–59.