Back to Homepage Income Measures Income: Saving and Investment Methods of Buying That Save Money The Choice of Goods Methods of Buying That Reduce Mistakes In Selection Methods of Securing Information Concerning Goods Plans and Motives of Consumers Consuming the Product Who Is the Consumer? The Consumer in the Market Priorities and Preferences in Consuming Decisions The Consumer as User of Wealth The Consumer as a Buyer Consumers as Self-Conscious Agents Criteria of a Good Market Information Versus Persuasion of the Buyer The Rate of Interest Interest Rates and Economic Activity Saving, Investment, and Income Saving Motives Saving Plans and their Realization Total Spending Is the Key to Prosperity The More We Spend, The More We Have Spending by Private Enterprise

The Rate of Interest Interest is a deterrent to investment since it is a cost which businessmen must pay when they invest. The higher the interest rate, the sharper the deterrent. But when the interest rate falls toward zero, investment is not always increased. A businessman will not invest if, in the best opportunity open to him, he expects to lose 20 per cent, even though interest were zero. Interest, therefore, has a one-sided effect: if the rate of interest rises extremely high -- 10, or 30 per cent a year -- investment will certainly be choked off. But lowering the rate of interest to zero will not necessarily stimulate investment. Interest is a payment made to lenders: a payment which induces them to give up their command over ready cash and accept, instead, a security or promise of repayment in the future. The higher the interest rate (assuming a given pattern of expectations about market conditions), the more money will be given up in loans by potential lenders of money; the lower the interest rate, the more will potential lenders be inclined to hold to cash in hope of a better chance turning up later. When the interest rate seems low, the risk to them from investing now is greater, since if the rate does rise an investor is likely to lose part of his capital. (A perpetual bond paying $2 a year when the interest rate is 2 per cent can be bought for $100. If the interest rate rises to 4 per cent, then 8 an investor can gain $2 a year by paying $50 for some other security; hence, no one will pay more than $50 for this particular bond. A doubling of the interest rate has led to a halving of its value, and the unfortunate man who first bought it has, in the effort to gain 2 per cent a year, lost half his capital.) If the banking system, perhaps as a consequence of Treasury and Federal Reserve policies, is flooding the country with cash, then the desire of individuals and institutions to invest in cash will be increasingly satiated. They will tend eventually to lend out increasing amounts at low interest rates rather than to keep on expanding their holdings of cash, and so continue to keep on losing the interest that is obtainable. A general expectation of low interest rates will tend to bring about their realization by increasing the willingness of holders of cash to lend. The Treasury and Federal Reserve, by conspicuously standing ready to lend at low rates on certain strategic securities, can diminish the fear of rising rates, and so assist in bringing about generally low rates. It is possible for the Treasury and Federal Reserve between them to push the interest rate downward even in a time of unexampled demand for loans. Average rates on United States Government securities fell, for example, from 2.3 per cent in 1942 to 1.9 per cent in 1944, despite an immense increase in borrowing for war purposes. Between the 1920's and 1930's, interest rates on all kinds of loans decreased. Loans by banks to their customers fell from a level averaging about 5 per cent in the middle of the 1920's to between 2 and 3 per cent in the late 1930's. This fall reflected in part government monetary policies, and in part it reflected outside influences which increased the ability of the banking system to lend at a time when demand for their loans from trustworthy borrowers was at low ebb. How important is the rate of interest? A low rate of interest, we have said, is a stimulant to investment since it reduces the cost of the funds which businessmen must use in investment. A high rate is a discouragement to investment. But how important an influence is the interest rate? The marginal efficiency of capital, or the gross profit expectation of businessmen, does not reflect only slow changes in the productivity of capital. It is specifically, we remember, an expectation, and so varies not only with the facts of the objective situation, but also with the confidence of the business manager. When the flow of investment spending is abruptly shriveled at the onset of depression, the explanation appears to be a general collapse of the marginal efficiency of capital, not a change in the interest rate. Suppose as is easily possible, the marginal efficiency of investment falls to negative levels: businessmen expect to lose money even on the best possibilities open to them. To offset the gloomy sentiments of business managers, one would have to charge negative rates to induce them to invest -- that is, subsidize them by letting them pay back less than they originally borrowed. This might conceivably be done, but it means loss to the lender, and so could not be done by any private banking system. The marginal efficiency of new investment to a businessman is likely to vary widely, from perhaps 100 per cent per year or more in warmth of optimism about a new process, new synthetic, new market, and so forth (and probably, on the average, human beings are more hopeful than events bear out), 10 minus 30 per cent from the best investment open, in the gloom of deep depression. For short-run investments in inventories and machinery, the calculations of businessmen are apt to be rough and ready: if a safe margin is not obtainable on inventories and if machinery is not expected to pay for itself in three or four years, the investment will not be undertaken. A fluctuation of interest rates within the ranges we have experienced in recent decades, say 6 to 2 per cent, is of secondary importance. For long-run investments, such as buildings, public utilities, ships, and railroads, where interest might be expected to bulk more largely in the mind of the businessman (since the interest will have to be paid over many years), the effect of varying rates is still likely to be moderate because of the dominating influence of the uncertainties of the future. Statistical studies carried on by Professor Tinbergen for the period 1919-1932 in the United States, indicate that the influence of interest rates was very small on changes in inventories and other short-term investments. The influence of interest rates on longterm investment was found moderate, "the influence of profits and, in the case of residential building, of the shortage and abundance of houses being much larger." What we have said minimizes, but does not deny, the influence of the interest rate. Some hesitant decisions will be influenced favorably toward investing by a fall in interest rates, and some will be influenced unfavorably by a rise in interest rates.   Home