§8. Market Equilibrium

We are now in a position to give a preliminary answer to the question, What determines the rate of interest? Thus far we have regarded the individual only, and have seen that he conforms his rate of income-impatience to the rate of interest. For him the rate of interest is a relatively fixed fact, since his own impatience and resulting action can affect it only infinitesimally. To him it is his degree of impatience which is the variable. In short, for him individually, the rate of interest is cause, and his lending and borrowing is the effect. For society as a whole, however, the order of cause and effect is reversed. This change is like the corresponding inversion of cause and effect in the theory of prices. Each individual regards the Edition: current; Page: [120] market price, say, of sugar, as fixed, and adjusts his marginal utility, or desirability, to it; whereas, for the entire group of persons forming the market, the adjustment is the other way around, the price of sugar conforming to its marginal desirability to the consumer.54 In the same way, while for the individual the rate of interest determines the degree of impatience, for society the degrees of impatience of the aggregate of individuals determine, or help to determine, the rate of interest. The rate of interest is equal to the degree of impatience upon which the whole community may concur in order that the market of loans may be exactly cleared.

To put the matter in figures: Suppose that at the outset the rate of interest is arbitrarily set very high, say, 20 per cent. There will be relatively few borrowers and many would-be lenders, so that the total extent to which would-be lenders are willing to reduce their income streams for the present year for the sake of a much larger future income will be, say, 100 million dollars; whereas, the extent to which would-be borrowers are willing to increase their income streams in the present at the high price of 20 per cent will be only, say, one million. Under such conditions the demand for loans is far short of the supply and the rate of interest will therefore go down. At an interest rate of 10 per cent the lenders may offer 50 millions, and the borrowers bid for 20 millions. There is still an excess of supply over demand, and interest must needs fall further. At 5 per cent we may suppose the market cleared, borrowers and lenders being willing to take or give respectively 30 millions. In like manner it can be shown that the rate would not fall below this, as in Edition: current; Page: [121] that case it would result in an excess of demand over supply and cause the rate to rise again.

Thus, the rate of interest registers in the market the common marginal rate of preference for present over future income, as determined by the supply and demand of present and future income. Those who, to start with, have a high degree of impatience, strive to acquire more present income at the cost of future income, and thus tend to raise the rate of interest. These are the borrowers, the spenders, the sellers of property yielding remote income, such as bonds and stocks. On the other hand, those who, to start with, have a low rate of preference, strive to acquire more future income at the cost of present income, and so tend to lower the rate of interest. Such are the lenders, the savers, the investors.

Not only will the mechanism just described result in a rate of interest which will clear the market for loans connecting the present with next year, but, applied to exchanges between the present and the more remote future, it will make similar clearings. While some individuals may wish to exchange this year's income for next year's, others wish to exchange this year's income for that of the year after next, or for a portion of several future years' incomes. The rates of interest for these various periods are so adjusted as to clear the market for each of the periods of time for which contracts are made.