Thinking about Interest and Irving Fisher

In two recent posts I have discussed Keynes’s theory of interest and the natural rate of interest. My goal in both posts was not to give my own view of the correct way to think about what determines interest rates,  but to identify and highlight problems with Keynes’s liquidity-preference theory of interest, and with the concept of a natural rate of interest. The main point that I wanted to make about Keynes’s liquidity-preference theory was that although Keynes thought that he was explaining – or perhaps, explicating — the rate of interest, his theory was nothing more than an explanation of why, typically, the nominal pecuniary yield on holding cash is less than the nominal yield on holding real assets, the difference in yield being attributable to the liquidity services derived from holding a maximally liquid asset rather than holding an imperfectly liquid asset. Unfortunately, Keynes imagined that by identifying and explaining the liquidity premium on cash, he had thereby explained the real yield on holding physical capital assets; he did nothing of the kind, as the marvelous exposition of the theory of own rates of interest in chapter 17 of the General Theory unwittingly demonstrates.

For expository purposes, I followed Keynes in contrasting his liquidity-preference theory with what he called the classical theory of interest, which he identified with Alfred Marshall, in which the rate of interest is supposed to be the rate that equilibrates saving and investment. I criticized Keynes for attributing this theory to Marshall rather than to Irving Fisher, which was, I am now inclined to think, a mistake on my part, because I doubt, based on a quick examination of Fisher’s two great books The Rate of Interest and The Theory of Interest, that he ever asserted that the rate of interest is determined by equilibrating savings and investment. (I actually don’t know if Marshall did or did make such an assertion.) But I think it’s clear that Fisher did not formulate his theory in terms of equating investment and savings via adjustments in the rate of interest rate. Fisher, I think, did agree (but I can’t quote a passage to this effect) that savings and investment are equal in equilibrium, but his analysis of the determination of the rate of interest was not undertaken in terms of equalizing two flows, i.e., savings and investment. Instead the analysis was carried out in terms of individual or household decisions about how much to consume out of current and expected future income, and in terms of decisions by business firms about how much available resources to devote to producing output for current consumption versus producing for future consumption. Fisher showed (in Walrasian fashion) that there are exactly enough equations in his system to solve for all the independent variables, so that his system had a solution. (That Walrasian argument of counting equations and unknowns is mathematically flawed, but later work by my cousin Abraham Wald and subsequently by Arrow, Debreu and McKenzie showed that Fisher’s claim could, under some more or less plausible assumptions, be proved in a mathematically rigorous way.)

Maybe it was Knut Wicksell who in his discussions of the determination of the rate of interest argued that the rate of interest is responsible for equalizing savings and investment, but that was not how Fisher understood what the rate of interest is all about. The Wicksellian notion that the equilibrium rate of interest equalizes savings and investment was thus a misunderstanding of the Fisherian theory, and it would be a worthwhile endeavor to trace the genesis and subsequent development of this misunderstanding to the point that Keynes and his contemporaries could have thought that they were giving an accurate representation of what orthodox theory asserted when they claimed that according to orthodox theory the rate of interest is what ensures equality between savings and investment.

This mistaken doctrine was formalized as the loanable-funds theory of interest – I believe that Dennis Robertson is usually credited with originating this term — in which savings is represented as the supply of loanable funds and investment is represented as the demand for loanable funds, with the rate of interest serving as a sort of price that is determined in Marshallian fashion by the intersection of the two schedules. Somehow it became accepted that the loanable-funds doctrine is the orthodox theory of interest determination, but it is clear from Fisher and from standard expositions of the neoclassical theory of interest which are of course simply extensions of Fisher’s work) that the loanable-funds theory is mistaken and misguided at a very basic level. (At this point, I should credit George Blackford for his comments on my post about Keynes’s theory of the rate of interest for helping me realize that it is not possible to make any sense out of the loanable-funds theory even though I am not sure that we agree on exactly why the loanable funds theory doesn’t make sense. Not that I had espoused the loanable-funds theory, but I did not fully appreciate its incoherence.)

Why do I say that the loanable-funds theory is mistaken and incoherent? Simply because it is fundamentally inconsistent with the essential properties of general-equilibrium analysis. In general-equilibrium analysis, interest rates emerge not as a separate subset of prices determined in a corresponding subset of markets; they emerge from the intertemporal relationships between and across all asset markets and asset prices. To view the rate of interest as being determined in a separate market for loanable funds as if the rate of interest were not being simultaneously determined in all asset markets is a complete misunderstanding of the theory of intertemporal general equilibrium.

Here’s how Fisher put over a century ago in The Rate of Interest:

We thus need to distinguish between interest in terms of money and interest in terms of goods. The first thought suggested by this fact is that the rate of interest in money is “nominal” and that in goods “real.” But this distinction is not sufficient, for no two forms of goods maintain or are expected to maintain, a constant price ratio toward each other. There are therefore just as many rates of interest in goods as there are forms of goods diverging in value. (p. 84, Fisher’s emphasis).

So a quarter of a century before Sraffa supposedly introduced the idea of own rates of interest in his 1932 review of Hayek’s Prices and Production, Fisher had done so in his first classic treatise on interest, which reproduced the own-rate analysis in his 1896 monograph Appreciation and Interest. While crediting Sraffa for introducing the concept of own rates of interest, Keynes, in chapter 17, simply — and brilliantly extends the basics of Fisher’s own-rate analysis, incorporating the idea of liquidity preference and silently correcting Sraffa insofar as his analysis departed from Fisher’s.

Christopher Bliss in his own classic treatise on the theory of interest, expands upon Fisher’s point.

According to equilibrium theory – according indeed to any theory of economic action which relates firms’ decisions to prospective profit and households’ decisions to budget-constrained searches for the most preferred combination of goods – it is prices which play the fundamental role. This is because prices provide the weights to be attached to the possible amendments to their net supply plans which the actors have implicitly rejected in deciding upon their choices. In an intertemporal economy it is then, naturally, present-value prices which play the fundamental role. Although this argument is mounted here on the basis of a consideration of an economy with forward markets in intertemporal equilibrium, it in no way depends on this particular foundation. As has been remarked, if forward markets are not in operation the economic actors have no choice but to substitute their “guesses” for the firm quotations of the forward markets. This will make a big difference, since full intertemporal equilibrium is not likely to be achieved unless there is a mechanism to check and correct for inconsistency in plans and expectations. But the forces that pull economic decisions one way or another are present-value prices . . . be they guesses or firm quotations. (pp. 55-56)

Changes in time preference therefore cause immediate changes in the present value prices of assets thereby causing corresponding changes in own rates of interest. Changes in own rates of interest constrain the rates of interest charged on money loans; changes in asset valuations and interest rates induce changes in production, consumption plans and the rate at which new assets are produced and capital accumulated. The notion that there is ever a separate market for loanable funds in which the rate of interest is somehow determined, and savings and investment are somehow equilibrated is simply inconsistent with the basic Fisherian theory of the rate of interest.

Just as Nick Rowe argues that there is no single market in which the exchange value of money (medium of account) is determined, because money is exchanged for goods in all markets, there can be no single market in which the rate of interest is determined because the value of every asset depends on the rate of interest at which the expected income or service-flow derived from the asset is discounted. The determination of the rate of interest can’t be confined to a single market.

20 Responses to “Thinking about Interest and Irving Fisher”


  1. 1 Henry November 13, 2015 at 12:55 pm

    David,
    I think it’s worth looking a little more closely at what Fisher said in “The Rate of Interest”:

    “This ‘time preference’ is the central fact in the theory of interest.” p.88
    “…….all time preference resolves itself into the preference for early income over later income.” p. 89
    “……the dependence on time preference on income is of most importance, for time preference is a preference for income.” p.103

    He went on to say that there were four “elements” which time preference depended on, viz., the size of the income stream, its distribution in time, its composition and its “probability”. p. 94

    Regarding the last of these, he said:
    “Income, being future, is always subject to some uncertainty, and this uncertainty must naturally have an influence on the rate of time-preference of the possessor.” p. 99

    He devoted Chapter XI to the analysis of risk and uncertainty, in which chapter he said early on:
    “…for in the concrete world, the most conspicuous characteristic of the future is its uncertainty.” p. 207

    It seems to me that Keynes’ treatment of the Liquidity Preference exhibits a resonance with Fisher’s treatment of time preference. At the base of Keynes’ LP is the propensity to hoard, at the base of the propensity to hoard, is the uncertainty of the future.

    You say Keynes’ Chapter 17 extends Fisher’s analysis, seeming to suggest that Keynes was undermining his own theory of the interest rate. I would like to suggest if Keynes extended anything (whether consciously or otherwise), his development of the theory of the LP had affinities with Fisher’s notions of time preference.

    Keynes also did a reasonable job of explaining why the classical idea of the saving/investment adjustment to an equilibrium interest rate was flawed in Chapter 14 of the GT, particularly p. 180-181. He argued that the classical version assumed a given level of income. He said the assumption that the level of income is constant is inconsistent with the notion that the S and I schedules could move independently of each other (GT p.179)

    Interestingly, Hansen (“Classical, Loanable-Fund, and Keynesian Interest Theories) agreed with Keynes but Hansen also argued that Keynes’ analysis was also indeterminate because the LP schedule shifted around with changes in income level. He said it was Hicks who eliminated this indeterminacy with his IS/LM schema. I think Hansen was being a little unfair to Keynes.

  2. 2 Henry November 13, 2015 at 2:05 pm

    Something else that’s worthy of note is Paul Davidson’s (Keynes’s Finance Motive) “rediscovery” of Keynes’ introduction of a fourth motive for the LP and that is the finance motive (Keynes, “Alternative Theories of the Rate of Interest” and “The Ex-ante Theory of the Rate of Interest”). Davidson develops the concept, highlighting the inaccuracies of the Hicks/Hansen interpretation of the GT and demonstrating that the LP includes financing for investment as another element. And, in a way, harking back to the loanable funds theory without including those aspects of it that Keynes found objectionable. Davidson’s paper is very interesting and inspired ongoing commentary and analysis. For instance, Horwich (“Keynes’s Finance Motive:Comment) argued that Davidson’s analysis was incomplete. I haven’t yet read the paper.

  3. 3 Rob Rawlings November 14, 2015 at 7:02 am

    “In general-equilibrium analysis, interest rates emerge not as a separate subset of prices determined in a corresponding subset of markets; they emerge from the intertemporal relationships between and across all asset markets and asset prices. To view the rate of interest as being determined in a separate market for loanable funds as if the rate of interest were not being simultaneously determined in all asset markets is a complete misunderstanding of the theory of intertemporal general equilibrium.’

    This is a very elegant way of stating things that I very much agree with.

    However I am not necessarily seeing it as incompatible with Keynes views on liquidity preference and the relationship between investment, savings and the rate of interest which i took you to be criticizing in your earlier posts. Indeed ( as I think you also now suggest?) Keynes was probably in agreement with you at least in some of his writings.

    On liquidity preference: Accepting the views you describe as the correct way to understand the structure of interest rates in the economy including the fact that money has a liquidity premia over other assets then it is still useful to identify that the money rate of interest is also the rate at which the entire money stock will be held , and if the liquidity premia alone changes then the money rate of interest will change without affecting the other own-rates.

    Likewise, it is useful to recognize that (in Keynes model) the flows of savings and investment must by necessity be equal, and what keeps them equal is the level of income not the interest rate. If people start to save a higher proportion of income (lower MPC) then the level of income will fall so that the flow of savings continues to match the flow of investment, with no necessity for underlying own-rates or the money rate of interest to change. The lowing of income may reduce the demand for money which will in turn reduce the money rate of interest, but this is a secondary effect that can happen with all other “own-rates” staying unchanged.

  4. 4 Miguel Navascués November 14, 2015 at 12:05 pm

    Perhaps thinking in only one interest rate is an excessive abstraction. So we are supposing that all the interest rate are represented by only one; when all the markets are in equlibrium, the spread between rates are constant. But that’s is the problem: what happens when different rates diverge in their search for a new equlibrium? The neoclassical “interest rate” is no more representative.
    Recently Olivier Blanchard said that he should add one more interest rate to the IS-LM model. I haven’t see a development of this idea, but I think he is right. During the crisis we have seen a high spread between treasury rates and BAA private a bond rates, quite sensible to the strength of the moment. In fact, this spread has not return to its historical level. I consider this fact Interesting, problematic for the GEM and in favor of Keynesian theories.

  5. 5 Miguel Navascués November 14, 2015 at 12:14 pm

    graph on BAA-Treassury rate spreadhttps://research.stlouisfed.org/fred2/graph/fredgraph.png?g=2yMx

  6. 7 Frank Restly November 15, 2015 at 10:02 am

    Henry,

    “It seems to me that Keynes’ treatment of the Liquidity Preference exhibits a resonance with Fisher’s treatment of time preference.”

    The liquidity of any asset is often defined as the ease of which one asset / good can be traded for other goods.

    Really liquid goods tend to have the following properties:
    1. They are easily transported across physical distances
    2. They have uniform agreed upon units of measure
    3. They are easily divided into smaller units of measure and recombined
    4. They are physically persistent – They do not decompose and are not easily destroyed

    “Liquid” is a description of the underlying asset. The only part of “liquid” that would apply to time preference would be 4. Physically persistent.

    If a good / asset is easily transported, has a set of uniform measurements, is easily divided and recombined, but is not physically persistent (the asset decomposes over time), the rate of interest that I lend that asset at will be a function of both my liquidity preference and how long that asset will continue to exist. I will accept less interest as the lifetime of the asset comes to expiration. Ie. I want 5% interest on newly harvested apples, I will accept 0.5% interest on 5 day old apples.

    Likewise, from Fisher:

    “…….all time preference resolves itself into the preference for early income over later income.”

    I don’t think Fisher meant only income received in the most liquid asset, or even income paid later with the same asset that was leant (apple interest for apples that are leant). Instead time preference stretches across goods – what interest rate would I lend apples at to receive a choo choo train 2 years from now. My early income is apples, my later income is a choo choo train.

  7. 8 Biagio Bossone November 15, 2015 at 1:22 pm

    Keynes fundamentally dealt with the role of time and uncertainty in a capitalist economy. He theorized that, faced with uncertainty, agents would not be interested in trading future income for present income, but rather illiquidity for liquidity. In Keynes’ new conception, the rate of interest ceased to be determined by the agents’ time preferences, but rather by their preferences for holding wealth in liquid and illiquid forms, respectively, coupled with the amount of the supply of wealth in the one form relatively to the supply of it in the other, given agents’ expectations, states of confidence, and beliefs across the agents.

    Accordingly, in a general equilibrium context, prevailing expectations, states of confidence and beilefs cause returns on existing assets (including physical capital) to reflect their different degrees of illiquidity. As a consequence, with the marginal efficiency of capital being inversely related to capital itself, a higher premium on liquidity – due to, say, higher perceived uncertainty and more pessimistic expectations – requires at equilibrium a higher return on capital to hold, leading in turn to a lower level of capital.

  8. 9 Henry November 15, 2015 at 1:47 pm

    Hi Frank,

    “Likewise, from Fisher:

    “…….all time preference resolves itself into the preference for early income over later (sic) income.””

    Fisher writes this on p. 89 of “The Rate of Interest”. On p. 94, he writes that time preference depends on the size, distribution in time, composition and probability of the income stream. I would imagine these ideas would fit reasonably well into Keynes’ ideas of the propensity to save and hoard. I guess Fisher didn’t treat with liquidity as a factor as Keynes did, however.

    And if you want to use apples as a store of value and as a means of exchange, you are very welcome to.

  9. 10 Frank Restly November 15, 2015 at 3:08 pm

    Henry,

    “And if you want to use apples as a store of value and as a means of exchange, you are very welcome to.”

    I was only using apples as an example in a non-monetary (barter) economy where loans are made. In such an economy, the rate of interest that is agreed to on a loan is a function of several factors – the relative persistence of one good versus another, the difference in production time between different goods, and the preference of both borrower and lender for liquid versus non-liquid goods.

    The presumption is that the most liquid good is always the one that is being lent. That need not be the case.

  10. 11 Henry November 15, 2015 at 6:59 pm

    Frank,

    “The presumption is that the most liquid good is always the one that is being lent. That need not be the case.”

    It may not need to be the case but isn’t it the most likely case? If I were the locomotive supplier the last thing I would want to be paid with is apples. So I think the point is that the apple rate of interest is not the one at play. I would argue that the more likely rate of interest at play is the monetary one. That’s what I think Keynes was on about.

  11. 12 Frank Restly November 16, 2015 at 3:50 pm

    Henry,

    “The presumption is that the most liquid good is always the one that is being lent. That need not be the case.”

    “It may not need to be the case but isn’t it the most likely case?”

    The good with the shortest production cycle is the one most likely to be lent. That is not necessarily the most liquid good.

    Consider share croppers of the early 19th century in the United States. During and after Southern reconstruction, large land owners would lend land to individuals looking to farm the land. In return the land owners would receive a portion of the harvest from the land.

    Land is hardly a liquid asset, but it has no production time (it already exists) which makes it more lendable than corn, wheat, apples, or even coins.

    Or if coinage is your thing, suppose individual coins were commissioned, designed, and hand engraved to the extent that creating an individual coin took months. Wouldn’t that inhibit their ability to be lent – irrespective of the “preferences” of the coin holder?

  12. 13 Egmont Kakarot-Handtke November 18, 2015 at 3:05 am

    How economic thinkers think they think about interest
    Comment on ‘Thinking about Interest and Irving Fisher’

    “Everything can be ‘explained’ if we place no restrictions on what we mean by ‘explanation’.” (Blaug, 1994, p. 123)

    David Glasner renders an exhaustive exegesis of the current state of the theory of interest. These are the highlights.

    Keynes: “Unfortunately, Keynes imagined that by identifying and explaining the liquidity premium on cash, he had thereby explained the real yield on holding physical capital assets; he did nothing of the kind, …” (See intro)

    Marshall: “the… classical theory of interest, … in which the rate of interest is supposed to be the rate that equilibrates saving and investment.”

    Fisher: “I [Glasner] doubt that … he ever asserted that the rate of interest is determined by equilibrating savings and investment.”

    Wicksell: “Maybe it was Knut Wicksell who in his discussions of the determination of the rate of interest argued that the rate of interest is responsible for equalizing savings and investment, but that was not how Fisher understood what the rate of interest is all about.”

    Robertson: “This mistaken doctrine was formalized as the loanable-funds theory of interest … in which savings is represented as the supply of loanable funds and investment is represented as the demand for loanable funds, with the rate of interest serving as a sort of price that is determined in Marshallian fashion by the intersection of the two schedules.”

    Glasner: “Why do I say that the loanable-funds theory is mistaken and incoherent? Simply because it is fundamentally inconsistent with the essential properties of general-equilibrium analysis. In general-equilibrium analysis, interest rates emerge not as a separate subset of prices determined in a corresponding subset of markets; they emerge from the intertemporal relationships between and across all asset markets and asset prices.”

    Rowe: “… there is no single market in which the exchange value of money (medium of account) is determined, because money is exchanged for goods in all markets, there can be no single market in which the rate of interest is determined because the value of every asset depends on the rate of interest at which the expected income or service-flow derived from the asset is discounted.”

    Conclusion: “The determination of the rate of interest can’t be confined to a single market.” (See intro) In other words, everything depends on everything else, in fact no price is determined in a single market, the economy is very complex and consists of stocks and flows, the future is uncertain, and, as Keynes always said: “We simply do not know.”

    However, the determination of the many nominal and real interest rates can be referred to General Equilibrium Theory because “my cousin Abraham Wald and subsequently … Arrow, Debreu and McKenzie showed that Fisher’s claim could, under some more or less plausible assumptions, be proved in a mathematically rigorous way.”

    It seems that the news got lost on David Glasner that General Equilibrium Theory is dead and buried since Sonnenschein/Mantel/Debreu (Ackerman et al., 2004).

    Because both — the Walrasian and the Keynesian — approaches are fundamentally (=axiomatically) flawed the theory of interest is flawed by logical implication. In order to develop the theory of interest from scratch (2011) one has — first of all — to refer Marshall, Keynes, Wicksell, Sraffa, Robertson, Fisher, Rowe, Glasner and some others from the set of scientific thinkers to the complementary set of confused confusers (2013).

    Egmont Kakarot-Handtke

    References
    Ackerman, F., and Nadal, A. (Eds.) (2004). Still Dead After All These Years:
    Interpreting the Failure of General Equilibrium Theory. London, New York, NY: Routledge.
    Blaug, M. (1994). Why I am Not a Constructivist. Confessions of an Unrepetant Popperian. In R. E. Backhouse (Ed.), New Directions in Economic Methodology, pages 109–136. London, New York, NY: Routledge.
    Kakarot-Handtke, E. (2011). Reconstructing the Quantity Theory (I). SSRN Working Paper Series, 1895268: 1–28. URL http://ssrn.com/abstract=1895268.
    Kakarot-Handtke, E. (2013). Confused Confusers: How to Stop Thinking Like an Economist and Start Thinking Like a Scientist. SSRN Working Paper Series,
    2207598: 1–16. URL http://ssrn.com/abstract=2207598

  13. 14 JKH November 18, 2015 at 3:08 am

    “Why do I say that the loanable-funds theory is mistaken and incoherent? Simply because it is fundamentally inconsistent with the essential properties of general-equilibrium analysis. In general-equilibrium analysis, interest rates emerge not as a separate subset of prices determined in a corresponding subset of markets; they emerge from the intertemporal relationships between and across all asset markets and asset prices.”

    I don’t agree with the loanable-funds theory, but I don’t understand this argument against it.

    Assume just for the sake of argument that loanable funds theory is correct. Then the interest rate determined by loanable funds should be the same as the general equilibrium rate through a simple arbitrage argument. If the rates diverge, then already existing asset stocks in the general equilibrium context will be bought or sold in order to bring the interest rate determined by their present value into equivalence with the interest rate determined on new flows in the loanable funds market.

    And as far as scope is concerned, there is nothing to suggest that the scope of the type of assets affected by the loanable funds market should be narrower than the full scope of outstanding assets. Loanable funds is not a “single market” in this sense.

    And the interest rate in either case is obviously intertemporal.

    Loanable funds theory can be rejected for other reasons.

  14. 15 Nick Rowe November 19, 2015 at 7:33 am

    Good post David. I hadn’t thought about the “no price is ever determined in just one market” critique of Loanable Funds theory.

    (I have spent the last 35 years trying to remember both the author and title of that big book on capital theory. You have cleared that one up for me. Bliss(!))

  15. 16 Egmont Kakarot-Handtke November 20, 2015 at 5:38 am

    Complementary time preferences and interest
    Comment on ‘Thinking about Interest and Irving Fisher’

    The first rule of economic analysis says that all real models are fundamentally flawed because the economy constitutes itself through the interaction of real and nominal variables, and therefore the proper analytical framework is given by — what Keynes called — the ‘monetary theory of production’.

    The most elementary economy is the pure consumption economy and it consists of the business and the household sector. For a start, the consolidated business sector produces and sells one consumption good.*

    First period: the business sector pays 100 monetary units (€, $ etc. *10exp) to the household sector and the household sector spends exactly this amount on the consumption good. There is no saving of the household sector. The business sector’s profit is zero and the price of the consumption good is equal to unit wage costs. This configuration reproduces itself without any change of the real variables labor input L, productivity R, and output O for an indefinite number of periods.

    Second period: one household saves 10 units (S=10) and intends to spend it after 20 periods, i.e. in t+20. If this happens without any dissaving from another household the business sector makes a loss (Q=-10). The market clearing price is in this case lower than constant unit wage costs.

    Since we focus here on pure time preference we have to make sure that the consumption expenditures of the household sector as a whole do not change. Hence, we need a second household who wants to dissave 10 units (=take up a loan) in this period and to pay it back after 20 periods. What is needed, then, is TWO households with exactly COMPLEMENTARY time preferences.

    In real terms, the saver household buys and consumes 10/P real units of the consumption good less in period t and exactly the same quantity more in period t+20. The dissaver household is again complementary in real terms. Together, the two households execute a nominal and real time transfer without affecting the rest of the economy. All possible but distracting side effects have been excluded.

    The real exchange over time presupposes complementary time preferences. Complementarity is what constitutes the market in the first place. If all households unanimously prefer real consumption now over real consumption in t+x there is no market for borrowing/lending to begin with.

    In order to focus on time preference alone risk is excluded. Then, the situation for the saver is this: he may hide the 10 monetary units for 20 periods under his mattress or lend it to the complementary household. On the other side, the dissaver/borrower household needs the 10 units now in order to carry out his plan.

    Obviously, the decision of the saver to hand the money over to the borrower has nothing to do with time preference. The saver has to make a second decision between keeping the money under the mattress or lending it (risk free) to the potential dissaver.

    It is this asymmetry which gives rise to the phenomenon of interest and NOT time preference as such. Time preference relates to the act of saving but not to the act of lending. Both are DISCONNECTED in time. And this means that — in principle — Keynes’s liquidity preference is a better explanation for the emergence of consumer interest than Fisher’s time preference (2013). Consumer interest, in turn, is disconnected from the rate of interest which the business sector pays for financing capital investment. Because of this, there is NO relationship at all between the households’ time preferences and the so-called marginal productivity of capital (2011).

    Methodologically correct thinking leads inescapably to the conclusion that thinking about interest and Irving Fisher is a pointless exercise.

    Egmont Kakarot-Handtke

    References
    Kakarot-Handtke, E. (2011). Squaring the Investment Cycle. SSRN Working Paper Series, 1911796: 1–25. URL
    http://ssrn.com/abstract=1911796
    Kakarot-Handtke, E. (2013). Settling the Theory of Saving. SSRN Working Paper Series, 2220651: 1–23. URL
    http://ssrn.com/abstract=2220651

    * The elementary interrelation of real and nominal variables in the pure consumption economy is shown in the following graphic

  16. 17 David Glasner November 25, 2015 at 9:06 am

    Egmont, Thanks for your summary. Obviously, I disagree with you on a number of points and I was unable to make any sense out of this the concluding paragraph of your comment of November 18. About complementarity of preferences, I would just point out that preferences can be exactly alike and yet trade can still take place if current endowments or expected future income streams are not the same. Thus, typically young people borrow from older people.

    JKH, My point is that the theoretical determinants of what the rate of interest is are reflected and help determine prices in a wide variety of markets for assets. Thus, the determination of the rate of interest cannot be isolated in a single or a narrow subset of markets in which supply and demand are largely dependent and influenced by prices established in many other markets.

    Nick, Thanks. Actually, I hadn’t thought of the point either until just before I wrote it down. The insight just came to me as I was writing and I felt that I had to share it. Glad you saw it and appreciated it.

  17. 18 Biagio Bossone November 25, 2015 at 10:56 am

    David Glasner

    “there can be no single market in which the rate of interest is determined because the value of every asset depends on the rate of interest at which the expected income or service-flow derived from the asset is discounted. The determination of the rate of interest can’t be confined to a single market.”

    This is precisely what lies behind Keynes’ liquidity preference theory, whereby the interest rate is not determined in one single market (the market for money), but rather by the demand for instruments that trade in all markets at low or zero transaction cost and at a sure nominal value against instruments that trade in all or in some markets at higher transactions costs and uncertain nominal values, relative to the supply of each. The higher the agents’ preference for the former – due to, say, higher uncertainty – the higher the interest rate premium required for agents to be persuaded to hold the latter. The interest rate, therefore, reflects the agents’ preference for being liquid versing being illiquid, at any point in time, as influenced by uncertainty, expectations, state of confidence, market mood, and changes thereof.

    David Glasner

    “Unfortunately, Keynes imagined that by identifying and explaining the liquidity premium on cash, he had thereby explained the real yield on holding physical capital assets; he did nothing of the kind…”

    Where uncertainty rises, the preference for liquidity rises, and raises with it the equilibrium return on illiquid instruments (see above), including physical capital. In fact, at the new higher level of the interest rate, the marginal efficiency of capital is lower, implying a lower level of the equilibrium capital stock. In Keynes’ analysis, it is the preference for liquidity that determines the equilibrium real yield on holding physical capital.


  1. 1 Links for 11-14-15 | Economics Blogs Trackback on November 14, 2015 at 12:11 am
  2. 2 Keynes on the Theory of the Rate of Interest | Uneasy Money Trackback on December 18, 2015 at 10:10 am

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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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