Economics Questions

Re: What is interest?

ivanfoofoo — Wed, 22 Jul 2009 14:00:15 GMT

Knight_of_BAAWA:

It means the cost of the risk and what you could be doing with the money (or other property) rather than lending it out. Interest is....rent.

Interest is not a cost, its a ratio (dimensionless quantity).

Esuric:

Interest is the return on capital. This is the way I understood it: The value of a capital good is determined by the value of the goods it can potentially make, but as a rule, it remains somewhat below it. The difference between the actual value of commodities produced and that of the capital good itself is called interest. Basically, people have time preferences, they value current goods more than future goods, and yet all production is aimed towards producing future goods. Some goods are produced in the distant future while others in the not so distant future. You pay the original means of production (land and labor) future prices while you sell your goods at current prices; this is what businessmen call "profit." The rate of interest, as people commonly understand it, would be represented by the capital market if the supply of potential investments were restricted by the actual supply of savings. A longer production processes is considered to be a more "roundabout" production process, and results in the highest possible long-term yield, but not short-term. There is a trade-off between the current and the future, or between consumption and savings. This is why you're willing to take 100 current dollars from the bank at the cost of 110 future dollars, and why you accept $40,000 a year (your wage) instead of $500,000 a decade. Or why you take $1120 every two weeks ($10 an hour, 8 hours every day) instead of $5000 a month. If you received your wage once all of the goods you produced actually entered the market, you would get paid more, but would have had to wait (inherent trade-off, since you prefer your money now). Again, if the interest rate on the capital market actually represented the time preference of society, you could place your money in an interest bearing account and receive the sum you would have gotten if you waited for your future salary. But again, you would most likely spend most of your income because you prefer current goods over future goods. Your wage rate, or your earning power will also effect your time preference. Those who make higher wages are willing to save large sums of their income because they have the ability to do both; while the poor don't have the ability to think for the future (save).

Interest is not the return on capital. Mises refuted that idea in Human Action, and he said that given that theory, land could only be traded with another land:

Ludwig Von Mises:

Originary interest is not "the price paid for the services of capital."[1] The higher productivity of more time-consuming roundabout methods of production which is referred to by Bohm-Bawerk and by some later economists in the explanation of interest, does not explain the phenomenon. It is, on the contrary, the phenomenon of originary interest that explains why less time-consuming methods of production are resorted to in spite of the fact that more time-consuming methods would render a higher output per unit of input. Moreover, the phenomenon of originary interest explains why pieces of usable land can be sold and bought at finite prices. If the future services which a piece of land can render were to be valued in the same way in which its present services are valued, no finite price would be high enough to impel its owner to sell it. Land could neither be bought nor sold against definite amounts of money, nor bartered against goods which can render only a finite number of services. Pieces of land would be bartered only against other pieces of land. A superstructure that can yield during a period of ten years an annual revenue of one hundred dollars would be priced (apart from the soil on which it is built) at the beginning of the second year at none hundred dollars, and so on.

When defining interest, is important to distinguish between the natural rate of interest and the market-determined rate of interest. The natural rate of interest is the ratio of the value assigned to want-satisfaction in the immediate future and the value assigned to want-satisfaction in remote periods of the future. The market-determined rate of interest has a "natural" part and the "market" part, determined by the supply and demand of loans.

Re: What is interest?

Esuric — Wed, 22 Jul 2009 05:09:36 GMT

garegin:

i thought mises said that there is no "average rate of profit". correct me if im wrong though

That probably has to do with the entrepreneurship aspect of profit. Again, I'm not entirely sure since I haven't read Kizner/Mises' theories of profit/entrepreneurship. Again, I do know that Marx confuses profits with interest, which is how he came up with the exploitation theory of labor (which really came from Smith). If a moderator could come in and verify/refute my understanding of capital theory it would be greatly appreciated.

Re: What is interest?

Esuric — Wed, 22 Jul 2009 05:07:09 GMT

mijokijo:

Okay, thanks for the help. Where else can I read some more about this subject?

Bohm-Bawerk: The Positive Theory of Capital, Capital and Interest

Hayek: Pure Theory of Capital

Ludwig Lachmann: Capital and Its Structure

I'm about to venture into capital theory myself, but this stuff is complicated. Keynes either didn't understand this concept, or simply chose to ignore it; though I do believe he accepted the productivity theory of capital.

Re: What is interest?

garegin — Wed, 22 Jul 2009 05:05:37 GMT

i thought mises said that there is no "average rate of profit". correct me if im wrong though

Re: What is interest?

mijokijo — Wed, 22 Jul 2009 05:02:14 GMT

Okay, thanks for the help. Where else can I read some more about this subject?

Re: What is interest?

Esuric — Wed, 22 Jul 2009 04:56:23 GMT

mijokijo:

So can we calculate interest outside of the loans market?

I understand time-preference, but I'm trying to understand interest outside of the loans market.

If you exclude entrepreneurship, I assume it would be the average rate of profits. I know it's the return to capital; this I'm sure of. Labor gets paid wages, land gets rent, and capital earns interest.

Re: What is interest?

mijokijo — Wed, 22 Jul 2009 04:52:21 GMT

So can we calculate interest outside of the loans market?

I understand time-preference, but I'm trying to understand interest outside of the loans market.

Re: What is interest?

Esuric — Wed, 22 Jul 2009 04:40:34 GMT

mijokijo:

So is interest always associated with loans or not? From your answers, I get the feeling that if we didn't have loans and had to invest using savings only that what is called 'profit' would also be equivalent to 'interest'. Is this true or have I misunderstood?

Interest only deals with the inherent trade-off between demand for current goods relative to future goods. This manifests itself in two ways, on the loan market, and on the exchange/production market. Money is a commodity, and is more valuable today relative to tomorrow, or one year from now; the same is true for apples and hammers. Yes, if banks were restricted by the supply of savings, meaning they couldn't inflate the money supply or engage in fractional reserve banking, the rate of interest would equal the average rate of profits (nearly). But this is only one part of profit, the second part, namely returns on entrepreneurship can still be earned. Now this part of profit differs amongst Austrian economists; but basically it's how smart or skillful the entrepreneur is. This is pretty sophisticated stuff, you should learn the basics first. I'm not sure I understand it since I haven't studied Bohm-Bawerk or Mises on entrepreneurship. My understanding, or lack-there off, comes from Mises and Hayek's short references to it in their trade cycle theories.

Re: What is interest?

mijokijo — Wed, 22 Jul 2009 04:27:51 GMT

So is interest always associated with loans or not? From your answers, I get the feeling that if we didn't have loans and had to invest using savings only that what is called 'profit' would also be equivalent to 'interest'. Is this true or have I misunderstood?

Re: What is interest?

garegin — Wed, 22 Jul 2009 03:00:07 GMT

interest is usury

Re: What is interest?

Esuric — Wed, 22 Jul 2009 02:46:43 GMT

mijokijo:

Hey all, I've seen this topic come up before, I've read Human Action completely including the section on originary interest, and I'm half-way through chapter 6 of MES regarding interest, yet my head hurts when I try to explain to myself or to anyone else what interest is and how it works. Let me ask my question:

What is interest? One answer is, "It is the cost of time," and I can understand that, but I can't explain what that means. Is interest always associated with loans? What does it mean that "Supplier of Present Goods = Demander of Future Goods" and vise versa? Is there someone else that explains interest better than Mises or Rothbard that I could read?

Interest is the return on capital. This is the way I understood it: The value of a capital good is determined by the value of the goods it can potentially make, but as a rule, it remains somewhat below it. The difference between the actual value of commodities produced and that of the capital good itself is called interest. Basically, people have time preferences, they value current goods more than future goods, and yet all production is aimed towards producing future goods. Some goods are produced in the distant future while others in the not so distant future. You pay the original means of production (land and labor) future prices while you sell your goods at current prices; this is what businessmen call "profit." The rate of interest, as people commonly understand it, would be represented by the capital market if the supply of potential investments were restricted by the actual supply of savings. A longer production processes is considered to be a more "roundabout" production process, and results in the highest possible long-term yield, but not short-term. There is a trade-off between the current and the future, or between consumption and savings. This is why you're willing to take 100 current dollars from the bank at the cost of 110 future dollars, and why you accept $40,000 a year (your wage) instead of $500,000 a decade. Or why you take $1120 every two weeks ($10 an hour, 8 hours every day) instead of $5000 a month. If you received your wage once all of the goods you produced actually entered the market, you would get paid more, but would have had to wait (inherent trade-off, since you prefer your money now). Again, if the interest rate on the capital market actually represented the time preference of society, you could place your money in an interest bearing account and receive the sum you would have gotten if you waited for your future salary. But again, you would most likely spend most of your income because you prefer current goods over future goods. Your wage rate, or your earning power will also effect your time preference. Those who make higher wages are willing to save large sums of their income because they have the ability to do both; while the poor don't have the ability to think for the future (save).

Re: What is interest?

Knight_of_BAAWA — Wed, 22 Jul 2009 02:14:51 GMT

It means the cost of the risk and what you could be doing with the money (or other property) rather than lending it out. Interest is....rent.

What is interest?

mijokijo — Wed, 22 Jul 2009 02:11:18 GMT

Hey all, I've seen this topic come up before, I've read Human Action completely including the section on originary interest, and I'm half-way through chapter 6 of MES regarding interest, yet my head hurts when I try to explain to myself or to anyone else what interest is and how it works. Let me ask my question:

What is interest? One answer is, "It is the cost of time," and I can understand that, but I can't explain what that means. Is interest always associated with loans? What does it mean that "Supplier of Present Goods = Demander of Future Goods" and vise versa? Is there someone else that explains interest better than Mises or Rothbard that I could read?