The Rate of Interest

Economics Economics Questions
1

In MES Rothbard continually argues that the rate of interest is set by time preference alone and not by the productivity of loans. This seems to me to be absolute nonsense. In chapter 6 section 7 Rothbard provided a critique of the neoclassical theory of the setting of the interest rate. In this he didn’t seem to really give a compelling reason as to why the productivity and demand for loans doesn’t play a part in the setting of the interest rate.

So here’s a praxeological attempt to explain why the interest rate would be set both by time preference and the productivity of loans.

Assumptions: Uniformity of the interest rate through competition, perfect certainty as to the yield of the loan, no increase in prices.

No individual will loan out money at a rate lower than their time preference, their valuation of current goods over future goods, so a borrower must offer at least enough money to satisfy the lender’s time preference. If a borrower is investing in capital goods and he knows that this investment will result in an increase in his profit margin of X, then he will be willing to pay at least X-.01 percent on the interest rate, but he can still pay a total of X on interest. Let’s indeed say that he is willing to pay the entirety of X for the loan because this will put his firm in a more advantageous state, however he will not pay more than X because then he believes that the loan is not justified.

Now let’s take a similar analysis of anticipated profit margins and apply them to other firms, but let’s say that the aggregate expected loan pay off is Y and all businesses are willing to pay an interest rate of Y in order to obtain their loan.

Fortuitously for the borrowers the time preferences of many are far lower than Y, and they are therefore willing to compete for loans. However, unless all of the time preference at the absolute minimum amount of money, offered that is to say Z, covers the loan, then the rate of interest will be bid up by the productivity of investment. If investment productivity did not matter then they would not be bid up any further than the minimum rate that ANY individual was willing to lend on the market. This is due to the fact that individuals will not invest at a loss. If no individual was willing to lend below a rate of 5 percent per year but no business was expecting to receive a profit of more than 2 percent, then no company would borrow funds or invest.

For one to maintain that expected profit margins from investment do not effect the rate of interest then this indeed does not take into account the fact that entrepreneurs will, all else equal, avoid running at a loss, and that if there is scarcity of a good, then individuals will bid up the price so long as the transaction is still mutually advantageous, so if there is a scarcity of loans at one rate, then it will be bid up by the purchasers of loans by offering a higher rate, bringing more investors into the market.

Please tell me what is wrong with my analysis, although I could have been more clear and concise I hope that I showed that all else equal borrowers will bid up the price depending on what they are willing to borrow at, and that depends upon what transaction is still advantageous, which in turn depends upon the expected contribution of the loan to a final product. This is praxeological.

I feel as though I must be misunderstanding Rothbard here, thoughts?

2

Bump

3

“The proportion of consumption to saving or investment is determined by people’s time preferences—the degree to which they prefer present to future satisfactions. The less they prefer them in the present, the lower will their time preference rate be, and the lower therefore will be the pure interest rate, which is determined by the time preferences of the individuals in society. A lower time-preference rate will be reflected in greater proportions of investment to consumption, a lengthening of the structure of production, and a building-up of capital. Higher time preferences, on the other hand, will be reflected in higher pure interest rates and a lower proportion of investment to consumption. The final market rates of interest reflect the pure interest rate plus or minus entrepreneurial risk and purchasing power components. Varying degrees of entrepreneurial risk bring about a structureof interest rates instead of a single uniform one, and purchasing-power components reflect changes in the purchasing power of the dollar, as well as in the specific position of an entrepreneur in relation to price changes. The crucial factor, however, is the pure interest rate. This interest rate first manifests itself in the “natural rate” or what is generally called the going “rate of profit.” This going rate is reflected in the interest rate on the loan market, a rate which is determined by the going profit rate.”-Murray Rothbard, America’s Great Depression

I don’t know what he said in MES, but he mentions here that the final rate takes other factors into account. The pure interest rate (which is probably what you’re referring to) intentionally leaves out risk and assumes perfect competition.

4

No such assumption of perfect competion can be made when the very concept itself is flat out rejected by Austrians. I believe you are reffering to the ERE (Evenly Rotating Economy).

5

First, a couple of things.

In Rothbard’s framework, the natural rate of interest is the premium on present goods (money that could be spent on consumption) over future goods (money earned from investment by selling the product). It excludes other factors that may make up a businesses’ “discounting” of future funds, such as the psychic, entrepreneurial risk, purchasing power and terms of trade components. In addition, it includes no entrepreneurial profit or loss. This “pure” rate of interest is determined by the supply curve of present goods, i.e capitalists supplying present goods for future goods, and the demand curve of present goods, i.e original factors supplying future goods in exchange for present goods now. Since the future goods supplied by factors is dependent on what people will spend on the product (the total amount spent on consumption), the interest rate is determined by the amount of money spent on consumption versus investment. This rivalrous bidding among factors and capitalists takes place among all the stages in the production structure and is only seen in its unalloyed form (no other components) and equalizing among all stages in the Evenly Rotating Economy. This “market”, along with the market for consumer loans, constitutues the formation of the pure interest rate. Since interest return is purely the result of time, the “independent productivity” of capital goods has no relevance to its formation, and therefore productivity plays no role in the interest rate.

Rothbard’s main point is that since the interest rate is determined purely by time preference, and since profit and loss are the result of discrepancies in factor prices and their DMVPs due to the uncertain world (which is intimately related to the interest rate), productivity does not have a positive relationship with expected returns (e.g. profit). An increase in investment that increases productivity may not increase profits, since the greater supply of goods sold at a lower price could bring in less total revenue and/or the rise in costs offsets enough the increased revenue. Profit is only realized by entrepreneurs when revenue is greater than the pure interest rate + other discounting components and factor prices are underpriced in relationship to their potential services. The demand curve that makes up manager’s demands for resources on the loanable funds market is dependent on expected returns to various investment projects based off of discrepancies in factor prices and their potential marginal value product, not productivity. In addition, as stated before, the producers loan market is completely dependent on the pure rate of interest formed in the production structure and not formed in the producers loan market. Unless the price spreads change in the production structure (relating to changed in time preference), there is no reason for a business to increase its demand curve.