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Interest rate: indicator of information or input for calculation?

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Koen Swinkels posted on Sun, Nov 9 2008 4:10 PM

I have some sort of problem with seeing the interest rate as an indicator, or a signal that somehow gives information that producers need (other than for purely calculational needs).

The producer doesn't need to take the information that the interest rate supposedly holds about people's time preferences into account, he only needs to calculate to see whether an investment makes sense and the interest rate plays a significant role in that calculation, he doesn't have to think about people's time-preferences that are *behind* that interest rate.

Does this make sense?

This is related of course to the calculation vs. knowledge debate (Mises vs. Hayek)

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No, it doesn't make any sense, because interest rates change the profitability of certain investments. If interest rates are high, then it is unprofitable to make certain investments in the short and medium term. However, if interest rates are low, more investments become profitable.

Take this as an example: You need to borrow $5k for an investment that will yield about 5% return annually. If the average interest rate is 10%, are you as likely to make that investment than if the average interest rate were 3%?

Your yield from investments also depends on the inflation rate. So if you make a $5k initial investment at 5% return and the inflation rate is low (say, 2%), your investment is profitable. But if the inflation rate suddenly jumps to five, six, or ten percent, you are actually losing money in real (inflation adjusted) terms.

The business cycle occurs when new credit enters the system and entrepreneurs miscalculate the profits they will yield from certain investments due to their uncertainty of future inflation. This is also why the rational expectations critique of ABCT makes no sense - if entrepreneurs knew ahead of time the inflation rate, they would simply bid up interest rates to their natural rate. However, since they do not know, a business cycle is possible unless the government actively fights inflation and succeeds (which is unlikely, due to the backwards looking nature of central banking).

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but that is exactly what I am saying, no? that it is about calculation, not about information (about time preferences). Am I misunderstanding you?

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No, there really isn't a distinction in this case. The economic calculation/information dichotomy only really applies to the debate over the possibility of socialism, AFAIK. In terms of business cycles, the lower interest rate really effects calculation in the sense that certain investment projects become profitable that previously were not. Even if one knows that a certain investment project will not be profitable in the long run due to inflation, you might be compelled to do it anyways due to the game theory effect.

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No, there really isn't a distinction in this case.

Interest rates are prices, so it is in a way relevant. His point is that the Hayekian way of viewing prices as transmitters of information breaks down here, as what matters is calculation.

-Jon

Freedom of markets is positively correlated with the degree of evolution in any society...

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