Production and Interest

Our present stock of means can only be used in two mutually exclusive ways: consumption or saving. For means that expire, the decision of how and when to employ them is simplified. If they are not consumed or used for production now, then they are lost forever. However, for durable means, we have the choice of employing them presently or employing them at a later time. The timing of the employing of means is further complicated because they can be employed for consumption or production. Because of time preference, the present valuations of both consumption and production carry a premium over their future counterparts. Present consumption is, ceteris paribus, valued more highly than future consumption because we exist in the present. The same can be said for production, but an important qualification must be made: the present value of any line of production has only derivative value. It derives its value from the consumable output of the line of production, which must be discounted because production takes time. It is because of this discount that interest emerges in markets for factors of production.

Interest is more plainly seen in the market for present money in terms of future money (credit market). Because of varying degrees of time preference, present money may be allocated to those with a higher willingness to pay in terms of future money. The relative spread between the future payment for a present loan is the interest rate in such a transaction. Because of competition for these loans, the market will tend toward a market-clearing interest rate.

Therefore, all entrepreneurs may compare an expected return on their investment in production with the expected return from lending to a borrower at the market interest rate. The tendency will be for these rates of return to equalize because a higher rate of return in, say, production will discourage lending (and so decrease the supply of loanable funds) and encourage spending on factors of production (and so bid up their prices). A decrease in the supply of loanable funds will allow the remaining suppliers to bid up the interest rate, and an increase in the price of factors of production means the costs of production are increased relative to the expected return and so the rate of return on production is diminished. The opposite scenario (interest rate is higher than rate of return in producing goods) results in the opposite tendencies and so the two rates of return will tend to equalize.

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