November 20, 2015

Complementary time preferences and interest

Comment on ‘Thinking about Interest and Irving Fisher’

Blog-Reference

The first rule of economic analysis says that all real models are fundamentally flawed because the economy constitutes itself through the interaction of real and nominal variables, and therefore the proper analytical framework is given by — what Keynes called — the ‘monetary theory of production’.

The most elementary economy is the pure production-consumption economy and it consists of the business and the household sector. For a start, the consolidated business sector produces and sells one consumption good.*

First period: the business sector pays 100 monetary units (€, $ etc. *10exp) as wage income to the household sector and the household sector spends exactly this amount on the consumption good. There is no saving of the household sector. The business sector’s profit is zero and the price of the consumption good is equal to unit wage costs. This configuration reproduces itself without any change of the real variables labor input L, productivity R, and output O for an indefinite number of periods.

Second period: one household saves 10 units (S=10) and intends to spend it after 20 periods, i.e. in t+20. If this happens without any dissaving from another household the business sector makes a loss (Q=-10). The market clearing price is, in this case, lower than constant unit wage costs.

Since we focus here on pure time preference we have to make sure that the consumption expenditures of the household sector as a whole do not change. Hence, we need a second household who wants to dissave 10 units (=take up a loan) in this period and to pay it back after 20 periods. What is needed, then, is two households with exactly complementary time preferences.

In real terms, the saver household buys and consumes 10/P real units of the consumption good less in period t and exactly the same quantity more in period t+20. The dissaver household is complementary in real terms. Together, the two households execute a perfectly synchronous nominal and real time transfer without affecting the rest of the economy. All possible but distracting side effects have been excluded.

The real exchange over time presupposes complementary time preferences. Complementarity is what constitutes the market in the first place. If all households unanimously prefer real consumption now over real consumption in t+x there is no market for borrowing/lending to begin with.

In order to focus on time preference alone risk is excluded. Then, the situation for the saver is this: he may hide the 10 monetary units for 20 periods under his mattress or lend it to the complementary household. On the other side, the dissaver/borrower household needs the 10 units now in order to carry out his plan.

Obviously, the decision of the saver to hand the money over to the borrower has nothing to do with time preference. The saver has to make a second decision between keeping the money under the mattress or lending it (risk-free) to the potential dissaver.

It is this asymmetry which gives rise to the phenomenon of interest and not time preference as such. Time preference relates to the act of saving but not to the act of lending. Both are disconnected in time. And this means that — in principle — Keynes’s liquidity preference is a better explanation for the emergence of consumer interest than Fisher’s time preference (2013). Consumer interest, in turn, is disconnected from the rate of interest which the business sector pays for financing capital investment. Because of this, there is no relationship at all between the households’ time preferences and the so-called marginal productivity of capital (2011).

Methodologically correct thinking leads inescapably to the conclusion that thinking about interest and Irving Fisher is a pointless exercise.

Egmont Kakarot-Handtke


References
Kakarot-Handtke, E. (2011). Squaring the Investment Cycle. SSRN Working Paper Series, 1911796: 1–25. URL
Kakarot-Handtke, E. (2013). Settling the Theory of Saving. SSRN Working Paper Series, 2220651: 1–23. URL

* The elementary interrelation of real and nominal variables in the pure production-consumption
economy is shown in the following graphic.

Immediately preceding post 'How economic thinkers think they think about interest'