Interest rate theory 275

through permeable sands is very wide, so that one well could ultimately drain a very
large reservoir. If time meaning the value of money were no object, that would
indeed be the best because it would be the cheapest way...If time were no object,
with zero rate of return or cost of capital, one well would drain a whole reservoir at
lowest cost.

These examples of substitutability at the margin between waiting and other

factors show that waiting can indeed enter into the production function.
The opportunity to wait for results is productive because it broadens the range
of production processes among which intelligent choices can be made. Business
firms will pay for such productive opportunities. Most obviously, they will pay
for loans enabling them to adopt more time-consuming production methods or
to install plant and equipment already embodying waiting along with other
factors. Firms demands for waiting (-avoidance) derive then from the pro-
ductivity of waiting and from consumers demands for goods produced with
its aid.
Counting the interest rate among factor prices offers a broadened view of
the subjective factors that can affect the interest rate. For example, suppose that
tastes shift away from poetry readings towards science fiction movies,
presumably a form of entertainment whose production is more roundabout or
waiting-intensive; hence the rate rises. The tastes that influence the interest rate
are not confined to direct time preferences between present and future con-
sumption. The pattern of tastes for different goods and services all demanded
at the same time also plays a role.

THE PERVASIVENESS AND FUNCTION OF THE

INTEREST RATE

As the foregoing examples suggest, interest is a pervasive phenomenon. It

appears not only in the explicit price of loans but also in price relations among
final goods, intermediate goods and factors of production. It even lurks in the
price relations between consumer goods embodying relatively large and
relatively small amounts of waiting.
This view of the interest rate fits in nicely with the view of the price system
as a transmitter of information and incentives. Like other prices, the interest
rate is a signaling and rationing device in allocating resources. In view of that
price, each business firm restrains its use of waiting. It restricts the amount of
value that it ties up over time in uncompleted processes of transforming primary
productive factors into final consumer goods and services. Prices similarly
restrain a firms employment of labor and land. But why should it restrain itself
if it could use additional waiting, labor, or land productively?
276 Monetary theory

The prices of scarce factors indicate that employing units of them in any
particular line of production has an opportunity cost. Prices of factors and
products force each business firm to consider whether additional factor units
would add not merely something to its output but also enough to the value of
its output to warrant the necessary sacrifice of valuable output elsewhere. Prices
enable the firm in effect to compare consumers evaluations of the additional
output it could offer and the cost as measured by consumers evaluations of
other goods forgone.
For example, constructing apartment buildings that will serve with little
maintenance for many years is a more waiting-intensive method of providing
housing services than constructing buildings with shorter lives or requiring
more current maintenance. Even though the more durable buildings require
more labor and other inputs in the first place, their services over their entire
lives will be greater in relation to inputs of these other factors. This does not
mean that constructing the more durable buildings is unequivocally advanta-
geous, for the longer average interval between inputs of resources and outputs
of services, as well as the fact that the economies in maintenance accrue not all
at once but only over time, imply an opportunity cost. That cost pertains to
other projects and products ruled out because the scarce capacity to wait has
been devoted to the durable apartments. The interest rate brings this cost to the
attention of business firms.
Prices also bring to the attention of consumers the opportunity costs of the
waiting (and other factors) embodied in the goods and services from which
they have to choose. It leads them to consult their preferences in the light of the
terms of choice posed in part by objective reality. It is perhaps an additional rec-
ommendation of the concept of waiting that without it Fisher (1930 [1955],
pp. 4857, 53441) denied that interest measures any genuine cost.8
We have one clarification. Waiting cannot be rationed by the interest rate
alone. For example, because of uncertainty about whether borrowers will repay,
lenders must practice nonprice rationing to some extent. They cannot grant
loans in whatever amount requested to all borrowers promising to pay the going
rate of interest.

FISHERS DIAGRAM AND HIS SEPARATION THEOREM

Figure 10.1 portrays a pure exchange economy, that is, one with no production.9
The vertical axis measures future consumption and the horizontal current or
present consumption. Given an initial endowment at point A, line MN is the
individuals budget or wealth constraint. Its slope equals (1 + r) where r is the
given market rate of interest at which he can borrow or lend. We assume perfect
and complete capital markets, so that the rate for borrowing is the same as the
 Interest rate theory 277

rate for lending. At point N the individual maximizes present consumption by

forgoing all future consumption. The opposite is true at point M. The initial
endowment point A lies on indifference curve U1. Through intertemporal
exchange the individual maximizes utility at point B on U2 by cutting current
consumption from CA to CB and thus increasing future consumption from FA
to FB. The individual lends at interest rate r. The slope of any straight line
tangent to an indifference curve measures the marginal rate of substitution
(MRS) between current consumption and future consumption at the point of
tangency. This slope equals (1 + rt) where rt is the marginal rate of time
preference (or IRD in terms of Chapter 2). At equilibrium point B the slope of
U2 (or MRS) equals the slope of budget constraint MN: (1 + rt) = (1 + r).
The given interest rate r therefore equals the individuals marginal rate of time
preference rt in equilibrium.
Figure 10.2 portrays an economy with production but no exchange. Curve PP
shows all production possibilities available to the individual given his initial
endowment at point A. The slope of any straight line tangent to PP measures
the marginal rate of transformation (MRT) of current consumption into future

Future M
consumption

FB B

A
FA U2
U1

N
CB CA Current or present
consumption

Figure 10.1 Pure exchange economy (no production)

278 Monetary theory

consumption at the point of tangency. This slope equals (1 + ri) where ri is

the marginal rate of return on investment in transforming forgone present goods
into future goods. Although point A lies on U1, through investment of CA CB
the individual maximizes utility at equilibrium point B on U2 where MRS =
MRT. Since (1 + rt) = (1 + ri), the individuals rate of time preference rt
equals the marginal rate of return on investment ri. Note that his consumption
in each period (CB and FB) equals his actual production in the absence of
exchange (Copeland and Weston, 1988, p. 8).

Future
consumption

FB B

FA A
U2
U1

P
CB CA Current or present
consumption

Figure 10.2 Production economy with no exchange

Figure 10.3, which is known as the Fisher diagram, portrays an economy

with production and exchange.10 With an initial endowment given by point A,
the individual invests CA CB in order to maximize wealth at point B, where
he reaches the highest attainable budget constraint MN. By borrowing at the rate
r, he maximizes utility at point D on U1 where he actually consumes CD and
FD. At equilibrium point D: MRS = MRT = slope of budget constraint MN.
That is: (1 + rt) = (1 + ri) = (1 + r). The individuals rate of time preference
rt equals the marginal rate of return on investment ri, both of which equal the
rate of interest r.
 Interest rate theory 279

Future M
consumption

FB
B
D
FD

FA
A

U1
P N
CB CD CA Current or present
consumption

Figure 10.3 Economy with production and exchange

The above analysis implies that the individuals decision process occurs in
two separate and distinct stages. First, he invests in order to reach the highest
attainable budget constraint MN. Second, through intertemporal exchange he
moves from point B on MN to point D, which is the optimal pattern of con-
sumption. Note that point D lies beyond the curve of production possibilities
(Humphrey, 1988, p. 5). This separation of the investment and consumption
decisions into two stages is what Hirshleifer calls Fishers separation theorem.
The first stage is governed solely by the objective criterion of maximizing
wealth (reaching the highest budget constraint), while the second stage is
governed by the individuals subjective time preferences concerning con-
sumption. This result implies that investment decisions can be delegated to the
firm, whose goal is to maximize wealth, without regard for the subjective time
preferences of its owners (Copeland and Weston, 1988, p. 12).
We emphasize that it is a mistake conceptually to identify the interest rate
with the marginal rate of time preference or the marginal rate of return on
investment. These various rates are mutually adjusting and only tend to become
equal. It is a serious error to identify magnitudes whose equality at the margin