INTEREST AND MONEY;DETERMINE EMPLOYMENT by lakpa sherpa samarpit

      

   It seems, then, that the rate of interest on money plays a peculiar part in setting a limit to the level of employment, since it sets a standard to which the marginal efficiency of a capital-asset must attain if it is to be newly produced. That this should be so, is, at first sight, most perplexing. It is natural to enquire wherein the peculiarity of money lies as distinct from other assets, whether it is only money which has a rate of interest, and what would happen in a non-monetary economy. Until we have answered these questions, the full significance of our theory will not be clear.

The money-rate of interest we may remind the reader is nothing more than the percentage excess of a sum of money contracted for forward delivery, e.g. a year hence, over what we may call the 'spot' or cash price of the sum thus contracted for forward delivery. It would seem, therefore, that for every kind of capital-asset there must be an analogue of the rate of interest on money. For there is a definite quantity of (e.g.) wheat to be delivered a year hence which has the same exchange value to-day as 100 quarters of wheat for 'spot' delivery. If the former quantity is 105 quarters, we may say that the wheat-rate of interest is 5 per cent per annum; and if it is 95 quarters, that it is minus 5 per cent per annum. Thus for every durable commodity we have a rate of interest in terms of itself;  a wheat-rate of interest, a copper-rate of interest, a house-rate of interest, even a steel-plant-rate of interest.

The difference between the 'future' and 'spot' contracts for a commodity, such as wheat, which are quoted in the market, bears a definite relation to the wheat-rate of interest, but, since the future contract is quoted in terms of money for forward delivery and not in terms of wheat for spot delivery, it also brings in the money-rate of interest. The exact relationship is as follows:

It follows from this that there is no reason why their rates of interest should be the same for different commodities,why the wheat-rate of interest should be equal to the copper- rate of interest. For the relation between the 'spot' and 'future' contracts, as quoted in the market, is notoriously different for different commodities. This, we shall find, will lead us to the clue we are seeking. For it may be that it is the greatest of the own-rates of interest which rules the roost (because it is the greatest of these rates that the marginal efficiency of a capital-asset must attain if it is to be newly produced); and that there are reasons why it is the money-rate of interest which is often the greatest (because, as we shall find, certain forces, which operate to reduce the own- rates of interest of other assets, do not operate in the case of money).

It may be added that, just as there are differing commodity-rates of interest at any time, so also exchange dealers are familiar with the fact that the rate of interest is not even the same in terms of two different moneys, e.g. sterling and dollars. For here also the difference between the 'spot' and 'future' contracts for a foreign money in terms of sterling are not, as a rule, the same for different foreign moneys.

Now each of these commodity standards offers us the same facility as money for measuring the marginal efficiency of capital. For we can take any commodity we choose, e.g. wheat; calculate the wheat-value of the prospective yields of any capital asset; and the rate of discount which makes the present value of this series of wheat annuities equal to the present supply price of the asset in terms of wheat gives us the marginal efficiency of the asset in terms of wheat. If no change is expected in the relative value of two alternative standards, then the marginal efficiency of a capital-asset will be the same in whichever of the two standards it is measured, since the numerator and denominator of the fraction which leads up to the marginal efficiency will be changed in the same proportion. If, however, one of the alternative standards is expected to change in value in terms of the other, the marginal efficiencies of capital-assets will be changed by the same percentage, according to which standard they are measured in. To illustrate this let us take the simplest case where wheat, one of the alternative standards, is expected to appreciate at a steady rate of a per cent per annum in terms of money; the marginal efficiency of an asset, which is x per cent in terms of money, will then be x − a per cent in terms of wheat. Since the marginal efficiencies of all capital-assets will be altered by the same amount, it follows that their order of magnitude will be the same irrespective of the standard which is selected.

There are three attributes which different types of assets possess in different degrees; namely, as follows:

(i) Some assets produce a yield or output q, measured in terms of themselves, by assisting some process of production or supplying services to a consumer.

(ii) Most assets, except money, suffer some wastage or involve some cost through the mere passage of time (apart from any change in their relative value), irrespective of their being used to produce a yield; i.e. they involve a carrying cost c measured in terms of themselves. It does not matter for our present purpose exactly where we draw the line between the costs which we deduct before calculating q and those which we include in c, since in what follows we shall be exclusively concerned with q − c.

(iii) Finally, the power of disposal over an asset during a period may offer a potential convenience or security, which is not equal for assets of different kinds, though the assets themselves are of equal initial value. There is, so to speak, nothing to show for this at the end of the period in the shape of output; yet it is something for which people are ready to pay something. The amount (measured in terms of itself) which they are willing to pay for the potential convenience or security given by this power of disposal (exclusive of yield or carrying cost attaching to the asset), we shall call its liquidity-premium .

It follows that the total return expected from the ownership of an asset over a period is equal to its yield minus its carrying cost plus its liquidity-premium, i.e. to q − c + l. That is to say, q − c + l is the own-rate of interest of any commodity, where q, c and l are measured in terms of itself as the standard.

It is characteristic of instrumental capital (e.g. a machine) or of consumption capital (e.g. a house) which is in use, that its yield should normally exceed its carrying cost, whilst its liquidity-premium is probably negligible; of a stock of liquid goods or of surplus laid-up instrumental or consumption capital that it should incur a carrying cost in terms of itself without any yield to set off against it, the liquidity-premium in this case also being usually negligible as soon as stocks exceed a moderate level, though capable of being significant in special circumstances; and of money that its yield is nil and its carrying cost negligible, but its liquidity-premium substantial. Different commodities may, indeed, have differing degrees of liquidity-premium amongst themselves, and money may incur some degree of carrying costs, e.g. for safe custody. But it is an essential difference between money and all other assets that in the case of money its liquidity- premium much exceeds its carrying cost, whereas in the case of other assets their carrying cost much exceeds their liquidity-premium. Let us, for purposes of illustration, assume that on houses the yield is q1 and the carrying cost and liquidity-premium negligible; that on wheat the carrying cost is c2 and the yield and liquidity-premium negligible; and that on money the liquidity-premium is l3 and the yield and carrying cost negligible. That is to say, q1 is the house-rate of interest, − c2 the wheat-rate of interest, and l3 the money-rate of interest.

To determine the relationships between the expected returns on different types of assets which are consistent with equilibrium, we must also know what the changes in relative values during the year are expected to be. Taking money (which need only be a money of account for this purpose, and we could equally well take wheat) as our standard of measurement, let the expected percentage appreciation (or depreciation) of houses be a1 and of wheat a2. q1, − c2 and l3 we have called the own-rates of interest of houses, wheat and money in terms of themselves as the standard of value; i.e. q1 is the house-rate of interest in terms of houses, − c2 is the wheat-rate of interest in terms of wheat, and l3 is the money-rate of interest in terms of money. It will also be useful to call a1 + q1, a2 − c2 and l3, which stand for the same quantities reduced to money as the standard of value, the house-rate of money-interest, the wheat-rate of money-interest and the money-rate of money-interest respectively. With this notation it is easy to see that the demand of wealth-owners will be directed to houses, to wheat or to money, according as a1 + q1 or a2 − c2 or l3 is greatest. Thus in equilibrium the demand-prices of houses and wheat in terms of money will be such that there is nothing to choose in the way of advantage between the alternatives;—i.e. a1 + q1, a2 − c2 and l3 will be equal. The choice of the standard of value will make no difference to this result because a shift from one standard to another will change all the terms equally, i.e. by an amount equal to the expected rate of appreciation  of the new standard in terms of the old.

Now those assets of which the normal supply-price is less than the demand-price will be newly produced; and these will be those assets of which the marginal efficiency would be greater (on the basis of their normal supply-price) than the rate of interest (both being measured in the same standard of value whatever it is). As the stock of the assets, which begin by having a marginal efficiency at least equal to the rate of interest, is increased, their marginal efficiency (for reasons, sufficiently obvious, already given) tends to fall. Thus a point will come at which it no longer pays to produce them, unless the rate of interest falls pari passu. When there is no asset of which the marginal efficiency reaches the rate of interest, the further production of capital-assets will come to a standstill.

Let us suppose (as a mere hypothesis at this stage of the argument) that there is some asset (e.g. money) of which the rate of interest is fixed (or declines more slowly as output increases than does any other commodity's rate of interest); how is the position adjusted? Since a1 + q1, a2 − c2 and l3 are necessarily equal, and since l3 by hypothesis is either fixed or falling more slowly than q1 or − c2, it follows that a1 and a2 must be rising. In other words, the present money-price of every commodity other than money tends to fall relatively to its expected future price. Hence, if q1 and − c2 continue to fall, a point comes at which it is not profitable to produce any of the commodities, unless the cost of production at some future date is expected to rise above the present cost by an amount which will cover the cost of carrying a stock produced now to the date of the prospective higher price.

It is now apparent that our previous statement to the effect that it is the money-rate of interest which sets a limit to the rate of output, is not strictly correct. We should have said that it is that asset's rate of interest which declines most slowly as the stock of assets in general increases, which eventually knocks out the profitable production of each of the others, except in the contingency, just mentioned, of a special relationship between the present and prospective costs of production. As output increases, own-rates of interest decline to levels at which one asset after another falls below the standard of profitable production; until, finally, one or more own-rates of interest remain at a level which is above that of the marginal efficiency of any asset whatever.