The Hayekian Triangle - interest rate and implications for the intertemporal structure of production

Economics Economics Questions
1

Recently I read the article by Bellante and Garrison named Philliips Curves and Hayekian Triangles (1988). The question I have is the following:

“Clearing the market for loanable funds in the face of such a monetary injection requires that the rate of interest falls until the quantity of funds demanded matches the increased supply.”

OK, thats obvious.

“In turn, this lowered rate of interest has implications for the intertemporal structure of capital. To the extent that the temporal relationship between the various types of capital goods and the ultimate output of the production processes is perceived by entrepreneurs, the prices of capital goods will be affected in a systematic way. In the earlier phases of the market’s reaction to the credit expansion, the greater the time between the use of the capital good and the emergence of the ultimate output, the greater the relative increase in the price of the capital good. This pattern of relative price changes follows from the application of standard discounting techniques. There will be a corresponding pattern of quantity adjustments. Capital will be bid away from relatively less time consuming processes and away from relatively late stages of production into relatively early stages of production…”

Can anybody please explain, why exactly entrepreneurs should favour for example investments in the mining industry for investments in the retailing sector? I’m reading Garrisons book Time and Money and this is exactly the question I have reding part 4 of his book. Sorry if it’s obvious but I just don’t get it.

2

The more distantly in the future they are situated, the higher the returns they offer (based on the interest rate.) Durable consumer goods/capital goods are sensitive to interest rates in this manner.

3

The thing you have to remember (and this confused me a while too) is that the Hayekian Triangle and the Structure of Production can be interpreted in many ways. The most commonly understood way is the “smokestack” industries that Garrison references. However, you also have to interpret it (and Garrison does list this, I just don’t have his book Time and Money right now but its in the beginning) that the Hayekian Triangle/Structure of Production as goods in process and a structure of production in all phases (I’m rushing this post right now, but he says it much more eloquently than I do). Entrepreneurs can make far off time discounted investments in the retail sector, or the more commonly understood “consumer goods sectors”.

So when Garrison says that “Capital will be bid away from less time consuming process” into earlier more time intensive/interest sensitive processes, the new projects started/operations expanded don’t always have to be in mining, refining or manufacturing like Garrison suggests, but in expansion of the service industry’s line of production as well (building huge skyscrapers, expanding long term planning on research and development , constructing big retail malls, etc). These lines of production are heavily interest sensitive and so a lowering of the interest rate greatly increases their profitability.

The problem is, however, that society still needs all those resources for later stages of production because time preferences haven’t changed (and actually increase as well, because the lower interest rate causes people to save even less). So while entrepreneurs are building big skyscrapers, houses, huge retail outlets, and expanding long term plans (Barring all of these are based more on the interest rate than consumer demand, I’m not a businessman), there is an ever increasing demand for F.O.P in later stages of production as there is an increase in consumer demand and businesses need clerks, shippers, and expansion into distributing and building less time intensive stores and other lines of production that are based more on consumer demand.

Hope this helps and I explained it clearly enough. At least this is how I understand it.

4
5

Thanks for your replies!

“The more distantly in the future they are situated, the higher the returns they offer (based on the interest rate.) Durable consumer goods/capital goods are sensitive to interest rates in this manner.”

Why are durable consumer goods/capital goods sensitive to the interest rate in this manner?

Assuming the Hayekian Triangle is depicted in 5 stages. Any good needs 1 year to pass each stage. The interest rate is at 10 %. Costs for an investment in the early stages benefit more if the interest rate falls to 5 %? Why?

Rothbard provides some calculations in “Man, Economy and State with Power and Market”, p 367 ff. I got some impression but honestly I’m getting even more confused.

What exactly is the time discount effect?

“So when Garrison says that “Capital will be bid away from less time consuming process” into earlier more time intensive/interest sensitive processes, the new projects started/operations expanded don’t always have to be in mining, refining or manufacturing like Garrison suggests, but in expansion of the service industry’s line of production as well (building huge skyscrapers, expanding long term planning on research and development , constructing big retail malls, etc). These lines of production are heavily interest sensitive and so a lowering of the interest rate greatly increases their profitability.What exactly is the derived demand effect?”

This would mean that on the left side of the Hayekian Triangle, in one interpretation, there are time consuming projects like for example, the construction of a new shopping mall, that takes many years for the errection of the buildings and so on. In another interpretation, the shopping mall is situated on the right side of the triangle, because it’s the retail sector. Am I wrong here?

Is it, that on the left side, there are projects which need more time to be completed? That would mean, on the right side, there could be - using Schiffs example- a restaurante owner, who experiences more guests while a circus comes to town. He buys a second restaurant (let’s assume it takes him 1 month to get it complete). When the circus leaves, far less people are interested in visiting the town and so, the restaurants experience fewer visitors and gets unprofitable. The circus can be interchanged by decreasing costs of consumer credits. (assuming that there are strong changes - ok this example is not my best) On the left side, there are projects like construction of a new automobile plant, that takes a few years for completion.

So, on the left side of the triangle, there are interest rate sensitive projects and on the right side, there are consumer demand sensitive projects???

Am I right?

What is the derived demand effect?

6

Because of +ve time preference. People prefer the same good now to the same good in the future (remember that: a good is homogeneous in its serviceability; if you want a good in the future because it is more useful then, we’re no longer talking about two homogeneous goods.) Capital goods and durable consumer goods provide services that extend into the future (presumably the more distantly situated in the future the more services the good will render, I need to go over the specifics of Austrian capital theory to figure out why this is again though aside from the effect of TP.) Consequently, the interest rate is relevant in assessing their serviceability.

It becomes cheaper because its costs are also in terms of interest. Bear in mind borrowing costs fall as such.

7

The time discount effect is when the profitability of a good increases as the interest rate is lowered. For example, starting a retailing business might base some of its profitability off of a decrease in the interest rate, but moreso on consumer demand (derived demand). Constructing a skyscraper for businesses to use for planning and production is heavily based off of the interest rate and not so much current consumer demand for products. Expansion into the “higher orders of production” (to use cloudy Austrian terminology) is when entrepreneurs make investments in goods whose profitability is more interest sensitive rather than based on consumer demand (derived demand effect).

Garrison explains these when he is talking about capital readjustment in the face of economic saving. People put more money in the loanable funds market and then interest rate is lowered (Surplus of funds, sellers reduce price to reduce QS and increase QD). Because consumers are consuming less (buying less consumer goods), the profitability of the later stages of production and industries based heavily on consumer demand go down. Businesses release these resources (in the case of labor, fire them) for expanding businesses to take them. Much like when a business that suffers from losses goes out of businesses and allows its factor’s of production to go to expanding businesses, the same thing occurs except with businesses across the time dimension and structure of production. The growing businesses are the ones whose profitability is based more the interest rate (the time discount effect). So, for example, the skyscraper whose construction requires a lot of capital goods and is highly interest sensitive will become more profitable when the interest rate is lowered.

So, for the sake of example, if society saves and stops consuming as much, they will buy less consumer goods and so businesses in retailing, distribution, final service industries will experience a decline and then release labor and other complementary goods to the construction of skyscrapers which entrepreneurs want to build with the new interest rate. As time goes on the project is completed, (lets say it is for a the research and production of new consumer goods). The production structure is lengthened, society has more capital producing capital which produces more consumer goods, and large quantities enter the markets that originally experienced a decline, further lowering their price (and through the law of interrelations of consumer goods, increasing of goods elasticity of demand for them which increases those businesses profitability), and improving society’s standard of living because now they are enjoying a better quality and greater supply of consumer goods at a lower price.

Using the triangle can be confusing when thinking of it like that. Basically, from my interpretation, if the construction of a mall is based more on time discount (lowering of the interest rate) rather than consumer demand, it is “on the left side”, and on the right side if vica versa. Determining whether an investment project is influenced more by interest rates or consumer demand and where they fall in the “Hayekian Triangle” is more business related as individual entrepreneurs make their own judgements on that. Thats why when saying something like a skyscraper, I am pretty confident its a “higher order good” because its heavily interest rate oriented as well as expansion into mining operations because the extraction of raw materials is not really dependent on the demand for the wide array of consumer goods they produce.