Editing Interest (section)

==Theories of interest==
===Aristotle's view of interest===
[[Aristotle]] and [[Scholasticism|the Scholastics]] held that it was unjust to claim payment except in compensation for one's own efforts and sacrifices, and that since money is by its nature sterile, there is no loss in being temporarily separated from it. Compensation for risk or for the trouble of setting up a loan was not necessarily impermissible on these grounds.{{sfn|Schumpeter|1954|p=61}}

===Development of the theory of interest during the seventeenth and eighteenth centuries===
[[Nicholas Barbon]] (c.1640–c.1698) described as a "mistake" the view that interest is a monetary value, arguing that because money is typically borrowed to buy assets (goods and stock), the interest that is charged on a loan is a type of rent – "a payment for the use of goods".<ref>Barbon, "A discourse of trade", 1690</ref>{{sfn|Schumpeter|1954|p=61}}<ref>William Letwin, "Origins of Scientific Economics: English Economic Thought, 1660–1776".</ref> According to Schumpeter, Barbon's theories were forgotten until similar views were put forward by [[Joseph Massie (economist)|Joseph Massie]] in 1750.{{refn|group=note|"Barbon's Discourse, on this point at all events, did not meet with success. The tract seems indeed to have been forgotten very soon. Thus, Barbon's fundamental idea remained in abeyance until 1750, when it was again expounded—for all we know, independently rediscovered—by Massie,<ref>{{cite book|last=Massie |first=Joseph |title=Essay on the Governing Causes of the Natural Rate of Interest |year=1750}}</ref> whose analysis not only went further than Barbon's but also gathered force from its criticism of the views of Petty and Locke."{{sfn|Schumpeter|1954|p=314}}}}

In 1752 [[David Hume]] published his essay "Of money" which relates interest to the "demand for borrowing", the "riches available to supply that demand" and the "profits arising from commerce". Schumpeter{{sfn|Schumpeter|1954}}{{page needed|date=June 2019}} considered Hume's theory superior to that of Ricardo and Mill, but the reference to profits concentrates to a surprising degree on 'commerce' rather than on industry.

[[Anne Robert Jacques Turgot|Turgot]] brought the theory of interest close to its classical form. Industrialists
<blockquote>share their profits with capitalists who supply the funds (''Réflexions'', LXXI). The share that goes to the latter is determined like all other prices (LXXV) by the play of supply and demand amongst borrowers and lenders, so that the analysis is from the outset firmly planted in the general theory of prices.{{refn|group=note|Schumpeter;{{sfn|Schumpeter|1954|p=316}} the references are to paragraph numbers in Turgot's "Réflexions sur la formation et la distribution des richesses" written in 1766, first published in 1769-70 in a journal, and then separately in 1776.}}</blockquote>

===<span id=classicalinterest>The classical theory of the interest rate</span>===
The classical theory was the work of a number of authors, including Turgot, [[David Ricardo|Ricardo]],{{refn|group=note|Isolated remarks in the chapters "Effects of accumulation on profits and interest" and "On currency and banks" in "Principles of political economy and taxation"}} [[Mountifort Longfield]],<ref>"Lectures on political economy", IX.</ref> [[John Stuart Mill|J. S. Mill]], and [[Irving Fisher]].<ref>"The rate of interest", 1907.</ref> It was strongly criticised by [[John Maynard Keynes|Keynes]]{{refn|group=note|"The general theory of employment, interest and money", especially the appendix to Chapter 14. Page numbers refer to the widely available edition published by Macmillan for the Royal Economic Society as part of Keynes's collected writings, which appear to correspond to those of the first edition.}} whose remarks nonetheless made a positive contribution to it.

Mill's theory is set out the chapter "Of the rate of interest" in his "Principles of political economy".{{refn|group=note|See also his chapters "Of the law of the increase of capital" and "Of profits"}} He says that the interest rate adjusts to maintain equilibrium between the demands for lending and borrowing.<ref>"Of the rate of interest", §1.</ref> Individuals lend in order to defer consumption or for the sake of the greater quantity they will be able to consume at a later date owing to interest earned. They borrow in order to anticipate consumption (whose relative desirability is reflected by the [[time value of money]]), but entrepreneurs also borrow to fund investment and governments borrow for their own reasons. The three sources of demand compete for loans.<ref>§2.</ref>

For entrepreneurial borrowing to be in equilibrium with lending:
<blockquote>The interest for money... is... regulated... by the rate of profits which can be made by the employment of capital...<ref>Ricardo, chapter "On currency and banks"</ref></blockquote>
Ricardo's and Mill's 'profit' is made more precise by the concept of the marginal efficiency of capital (the expression, though not the concept, is due to Keynes{{refn|group=note|Chapter 11 of The General Theory is titled "The Marginal Efficiency of Capital." [[Alfred Marshall|Marshall]] used the term ''marginal utility of capital'' and Fisher ''rate of return over cost''. Fisher also referred to it as representing the "investment opportunity side of interest theory".}}), which may be defined as the annual revenue which will be yielded by an extra increment of capital as a proportion of its cost. So the interest rate ''r'' in equilibrium will be equal to the marginal efficiency of capital ''r{{'}}''. Rather than work with ''r'' and ''r{{'}}'' as separate variables, we can assume that they are equal and let the single variable ''r'' denote their common value.

[[File:Millinterestrate.svg|thumb|Classical theory of the determination of the interest rate. The solid red curve in the diagram shows the desired level of saving ''s'' as a function of ''r'' for the current income ''y&#x0302;''.]]

The investment schedule ''i'' (''r'') shows how much investment is possible with a return of at least ''r''.{{refn|group=note|Keynes called this function the 'schedule of the marginal efficiency of capital' and also the 'investment demand schedule'.}} In a stationary economy it is likely to resemble the blue curve in the diagram, with a step shape arising from the assumption that opportunities to invest with yields greater than ''r&#x0302;'' have been largely exhausted while there is untapped scope to invest with a lower return.<ref name="Mill §3; Longfield">Mill §3; Longfield.</ref>

Saving is the excess of deferred over anticipated consumption, and its dependence on income is much as described by Keynes (see [[The General Theory of Employment, Interest and Money#bookiii|The General Theory]]), but in classical theory definitely an increasing function of ''r''. (The dependence of ''s'' on income ''y'' was not relevant to classical concerns prior to the development of theories of [[unemployment]].) The rate of interest is given by the intersection of the solid red saving curve with the blue investment schedule. But so long as the investment schedule is almost vertical, a change in income (leading in extreme cases to the broken red saving curve) will make little difference to the interest rate.

In some cases the analysis will be less simple. The introduction of a new technique, leading to demand for new forms of capital, will shift the step to the right and reduce its steepness.<ref name="Mill §3; Longfield"/> Or a sudden increase in the desire to anticipate consumption (perhaps through military spending in time of war) will absorb most available loans; the interest rate will increase and investment will be reduced to the amount whose return exceeds it.<ref>§3.</ref> This is illustrated by the dotted red saving curve.

====<span id=keynescriticisms>Keynes's criticisms</span>====
In the case of extraordinary spending in time of war the government may wish to borrow more than the public would be willing to lend at a normal interest rate. If the dotted red curve started negative and showed no tendency to increase with ''r'', then the government would be trying to buy what the public was unwilling to sell at any price. Keynes mentions this possibility as a point "which might, perhaps, have warned the classical school that something was wrong" (p.&nbsp;182).

He also remarks (on the same page) that the classical theory does not explain the usual supposition that "an increase in the quantity of money has a tendency to reduce the rate of interest, at any rate in the first instance".

Keynes's diagram of the investment schedule lacks the step shape which can be seen as part of the classical theory. He objects that
<blockquote>the functions used by classical theory... do not furnish material for a theory of the rate of interest; but they could be used to tell us... what the rate of interest will have to be, if the level of employment [which determines income] is maintained at a given figure.<ref>p181.</ref></blockquote>

Later (p.&nbsp;184) Keynes claims that "it involves a circular argument" to construct a theory of interest from the investment schedule since 
<blockquote>the 'marginal efficiency of capital' partly depends on the scale of current investment, and we must already know the rate of interest before we can calculate what this scale will be.</blockquote>

===Theories of exploitation, productivity and abstinence===
The classical theory of interest explains it as the capitalist's share of business profits, but the pre-marginalist authors were unable to reconcile these profits with the [[labor theory of value]] (excluding Longfield, who was essentially a marginalist). Their responses often had a moral tone: Ricardo and Marx viewed profits as exploitation, and [[John Ramsay McCulloch|McCulloch]]'s productivity theory justified profits by portraying capital equipment as an embodiment of accumulated labor.{{sfn|Schumpeter|1954}}{{page needed|date=June 2019}} The theory that interest is a payment for abstinence is attributed to [[Nassau William Senior|Nassau Senior]], and according to Schumpeter{{sfn|Schumpeter|1954}}{{page needed|date=June 2019}} was intended neutrally, but it can easily be understood as making a moral claim and was sharply criticised by Marx and [[Ferdinand Lassalle|Lassalle]].

===<span id=wicksellinterst>Wicksell's theory</span>===
[[Knut Wicksell]] published his "Interest and Prices" in 1898, elaborating a comprehensive theory of economic crises based upon a distinction between natural and nominal interest rates. 
<blockquote>Wicksell's contribution, in fact, was twofold. First he separated the monetary rate of interest from the hypothetical "natural" rate that would have resulted from equilibrium of capital supply and demand in a barter economy, and he assumed that as a result of the presence of money alone, the effective market rate could fail to correspond to this ideal rate in actuality. Next he supposed that through the mechanism of credit, the rate of interest had an influence on prices; that a rise of the monetary rate above the "natural" level produced a fall, and a decline below that level a rise, in prices. But Wicksell went on to conclude that if the natural rate coincided with the monetary rate, stability of prices would follow.<ref>[[Étienne Mantoux]], "Mr Keynes' ''General Theory''", ''Revue d'Économie Politique'', 1937, tr. in [[Henry Hazlitt]], "The critics of Keynesian economics", 1960.</ref></blockquote>
In the 1930s Wicksell's approach was refined by [[Bertil Ohlin]] and [[Dennis Robertson (economist)|Dennis Robertson]] and became known as the [[loanable funds]] theory.

===Austrian theories===
[[Eugen Böhm von Bawerk]] and other members of the [[Austrian School]] also put forward notable theories of the interest rate.

The doyen of the Austrian school, [[Murray Rothbard]], sees the emphasis on the loan market which makes up the general analysis on interest as a mistaken view to take. As he explains in his primary economic work, ''Man, Economy, and State'', the market rate of interest is but a ''manifestation'' of the natural phenomenon of time preference, which is to prefer present goods to future goods.{{Sfn|Rothbard|2001}} To Rothbard, {{quote|Too many writers consider the rate of interest as only the price of loans on the loan market. In reality...the rate of interest pervades all time markets, and the productive loan market is a strictly subsidiary time market of only derivative importance.{{Sfn|Rothbard|2001|p=371}}}}

Interest is explainable by the rate of time preference among the people. To point to the loan market is insufficient at best. Rather, the rate of interest is what would be observed between the "stages of production", indeed a time market itself, where capital goods which are used to make consumers' goods are ordered out further in time away from the final consumers' goods stage of the economy where consumption takes place. It is ''this'' spread (between these various stages which will tend toward uniformity), with consumers' goods representing present goods and producers' goods representing future goods, that the real rate of interest is observed. Rothbard has said that {{quote|Interest rate is equal to the rate of price spread in the various stages.{{Sfn|Rothbard|2001|p=371}}}} Rothbard has furthermore criticized the Keynesian conception of interest, saying {{quote|One grave and fundamental Keynesian error is to persist in regarding the interest rate as a contract rate on loans, instead of the price spreads between stages of production.{{Sfn|Rothbard|2001|p=789}}}}

===Pareto's indifference===
[[Vilfredo Pareto|Pareto]] held that
<blockquote>The interest rate, being one of the many elements of the general system of equilibrium, was, of course, simultaneously determined with all of them so that there was no point at all in looking for any particular element that 'caused' interest.{{refn|group=note|Unsourced observation in Schumpeter{{sfn|Schumpeter|1954|p=892}}}}</blockquote>

===<span id=keynesinterest>Keynes's theory of the interest rate</span>===
{{See also|Robinson Crusoe economy#Money as the origin of interest}}
Interest is one of the main components of the economic theories developed in [[Keynes]]'s 1936 ''[[The General Theory of Employment, Interest and Money]]''. In his initial account of [[liquidity preference]] (the demand for money), this demand is solely a function of the interest rate; and since the supply is given and equilibrium is assumed, the interest rate is determined by the money supply. He later writes that interest cannot be separated from other economic variables and needs to be analysed together with them.

Keynes acknowledged that the German-Argentine economist [[Silvio Gesell]] developed some of the central elements of a precursor theory of interest, decades before he published ''The General Theory of Employment, Interest and Money'' in 1936.<ref name="keynes-on-gesell">{{cite book |last=Keynes |first=John Maynard |date=February 1936 |title=The General Theory of Employment, Interest and Money |url=https://userpage.fu-berlin.de/~roehrigw/keynes/engl.htm |location=London |publisher=Macmillan |via=Freie Universität Berlin |chapter=Book 6, Chapter 23: Notes on Mercantilism, The Usury Laws, Stamped Money and Theories Of Under-Consumption |isbn=978-0-230-00476-4 |access-date=30 April 2025 |quote=It is convenient to mention at this point the strange, unduly neglected prophet Silvio Gesell (1862-1930), whose work contains flashes of deep insight and who only just failed to reach down to the essence of the matter. In the post-war years his devotees bombarded me with copies of his works; yet, owing to certain palpable defects in the argument, I entirely failed to discover their merit. As is often the case with imperfectly analysed intuitions, their significance only became apparent after I had reached my own conclusions in my own way.}}</ref>
Gesell created a [[Robinson Crusoe economy]] [[thought experiment]] which showed that interest rates tend to exist in monetary economies while not existing in [[barter]] economies.<ref name="NEO-part-5-chap-1">{{Cite web |last=Gesell |first=Silvio |title=Die natürliche Wirtschaftsordnung durch Freiland und Freigeld |trans-title=The Natural Economic Order/Part V/A Story of Robinson Crusoe |date=1916 |location=Bern, Switzerland |translator-last=Pye |translator-first=Philip |via=The Anarchist Library |url=https://theanarchistlibrary.org/library/silvio-gesell-the-natural-economic-order#toc79 |archive-url=https://web.archive.org/web/20250317140424/https://theanarchistlibrary.org/library/silvio-gesell-the-natural-economic-order |archive-date=17 March 2025 |access-date=30 April 2025 |df=dmy-all |isbn=9781610330442}}</ref>
Gesell identified that interest rates are a purely monetary phenomenon,<ref name="sidman-lecture-6">{{cite AV media |last=Sidman |first=Josh |date=3 April 2024 |title="Silvio Gesell: Beyond Capitalism vs Socialism" Class #6 |url=https://www.youtube.com/watch?v=1GjX4PCcTlU |type=Video |language=English |publisher=Henry George School of Economics |access-date=30 April 2025}}</ref> but Keynes believed that Gesell's theory only amounted to "half a theory",<ref name="baynham-2023">{{cite web |url=https://www.noemamag.com/what-if-money-expired/ |title=What If Money Expired? |last=Baynham |first=Jacob |date=14 November 2023 |website=Noema Magazine |publisher=Berggruen Institute |access-date=26 April 2025}}</ref> since Gesell failed to discern the importance of liquidity.
Keynes improved upon Gesell's theory of interest by explicitly recognizing that money has the advantage of liquidity over commodities.