Money demand and interest rates

by Robert ten Hoor 31. oktober 2017 15:30

 

Companies compete with each other on the price of their products. Theoretically, and over a period of time, the product with the lowest price should be sold the most. Because of the competition between companies, the prices of products should decline to the cost of production. Companies that cannot match a price will not survive over the long term and the product price should therefore tend towards the production cost. So goes the theory.

 

Investment

The cost price of production can, most of the time, be reduced by investing. For example, in advantages of scale or new technology. Investment can also be done into making better or more useful products.

The investment made will have a return: It should lead to more profit for the investing company.

If a company produces a certain product and buys a new, bigger robot to produce the product, it could lower its cost per product. This will increase profit, at least until the competition makes the same investment… The increase in profit is the return on the investment.

How big the return on investment is and how long it lasts, depends on the technology, the current industry structure, etc.

For the investor, the return on investment needs to be more than the rate at which money can be borrowed. If the return is less, it does not make sense to invest. If the return is more than the borrowing cost, investments will be profitable and more investments will be done until the yield reaches the interest rate.

Looking at an entire economy, there will be many investment opportunities. Some will yield more than others. Theoretically, the higher yield ones will get the new investments first, then the investment with the next lower yield etc. The process will stop when the lowest available interest rate has been reached. In this way, the level of investment (and probably the growth rate of the economy) will depend on the going interest rate.

 

Demand for money

Suppose there is a new disruptive technology that reduces production cost. The yield on the investment of applying this new technology will initially be high. If the new yield is higher than the market interest rate, the demand for money will increase. The interest rate in the economy should then go up.

The same should happen if the population grows: more demand for products will make investments better yielding and will increase the demand for money.

In a previous article it was noted that, historically, the money supply does not the entire story make. There have been many times where a lot of money supply (like gold from America pouring into Europe in the 1600’s) did not lead to lower interest rates.

My guess is that the price of money (i.e. the interest rate) is determined by the supply AND demand of money.

 

Current low interest rates

The world population is currently aging and a lot of countries are already declining in population numbers. This reduces total consumption demand and thus production. In a situation of economic shrinkage, investments will not be very worthwhile (assuming the same technology). Demand for money will generally decline and this will mean that the market interest rate declines.

 

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