OK, I’m still wrestling with the Ricardo Effect. Let’s assume voluntary savings have surged upward, for some reason. Assuming no artificial influences, the savings came at the expense of consumer spending. As a result, consumer prices have dropped. All the new funds that the new savers are providing, being available for more loans pushes interest rates down. I know that longer term projects which are often financed long term are far more sensitive to interest rate changes than short term ones. As an example, a small change in interest rates will wield a huge effect on monthly payments and total cost of a 30 yr. mortgage, where as it would be a more negligible effect on a 3 yr. Loan.
This causes me to think that capital goods, which are often financed long term, are going to be less expensive as a result of the drop in interest rates. Am I right about this? Is the nominal price of capital goods dropping in this situation? Or maybe I should ask, is the nominal price of capital goods plus interest payments less than the combination of the two were previously? If this is the case, then I can see why entrepreneurs choose capital goods as opposed to labour. When contemplating choosing between the two, one (capital goods) has gotten cheaper than the other. I don’t see how it has anything to do with the fact that “real wages” have increased. Anyone???
The Ricardo effect is wrong; it confuses causality. A fall in the interest rate will see the price of producer goods rise relative to consumer goods. Consumer goods will see their prices fall more dramatically, since they are at the earliest phases of production–they see the money first. The goods at the higher stages of production will have their prices fall relatively less than the lower phases, or not fall at all. As the interest rate falls, investment becomes cheaper (forced investment) and entrepreneurs will produce the goods with the highest prices (want to maximize profit). Again, this shifts their aims towards the higher phases (intermediary goods). The structure of production will become lengthened; there will be more capital available, but a relatively fixed supply of labor, which increases the demand for labor (their productivity will increase because there’s more capital available to them, more tools). As a result, wages will rise, and incomes will rise, but profits for the capitalists will fall, either in relative or absolute terms. Higher incomes means that consumers could save more and spend more, or, they may save the same amount and spend more–essentially, the pie grows. For every firm that produces a finished good, that is, a good ready for immediate consumption, there is a multiple of firms that produced the inputs required for the final output.
It’s also important to note that short-term interest rates also finance more roundabout methods of production. Producers can continuously borrow short.