Productive borrowers seek a profit on their investments
4. In the long-time money loan the money generally is borrowed first merely as a medium of exchange to get control of indirect agents. The borrower of a long-time money loan for productive purposes is always seeking to gain by investing the money in wealth that will yield an income larger than the interest he must pay. The borrower, therefore, invests in view of the rate of interest, of the market price of the goods in which he plans to invest, and of the probable chances for earning profits in the business. This case, where certain goods whose price is known are approximately selected before the money is borrowed for investment, is the type of loan to be kept most usually in mind in economic discussion.
Evidently the price of these goods, to control which is the real object of the loan, is merely the sum of the expected rents they will yield, capitalized at the prevailing rate of time-discount. The borrower expects either to make these particular goods earn rents larger than those on the basis of which they have been capitalized, or to transfer them to an economy where goods are capitalized at a higher rate than he is paying. The income yielded by these goods, if the borrower's expectation is fulfilled, is but the difference between present and future rents that has been wrapped up in their capitalization. As time elapses and the rents emerge in wisely chosen investments, the borrower has a surplus large enough to pay the contract interest. It appears, therefore, that the motive of the borrower is to get control of future rents at prices that already involve, in their capitalization, a rate of discount somewhat greater than the interest he contracts to pay.
The developed market for money loans
5. The rate of contract interest on money loans is adjusted at each moment in the money market by the bidding for money loans. This is a true statement only if it is understood in a somewhat superficial sense. No error connected with interest is, however, more crude than the view that the interest rate is in any broad sense due to the quantity of money. Some loans are made apart from the general market, by private agreement between borrower and lender; but in nearly every such case the rate agreed upon is seen to be closely related to that of the general market to which either borrower or lender can resort if he wishes. The greater number of borrowers and lenders of money have a range of choice in their bargaining. The interest rate in modern developed money markets is that rate which brings to equilibrium the demand for money loans and the money capital available within the period. If the ready, loanable money in private hands, in banks, in insurance-company reserves, &c., increases, a lower rate must be offered to borrowers; if the supply decreases, a higher rate will be quoted. In the one case, more men borrow; in the other, fewer borrow and more seek to lend. Thus a rate results, but a rate that is closely connected with larger set of facts—those, indeed, which determine in the long run the rate of capitalization in the community.
Every person is a buyer or a seller of present goods
6. The individual must adjust his business dealings to the market rate of interest. The market rate is fixed by the bidding of individuals, and every one has something to do with fixing it. In a multitude of minutely small ways, as present and future goods are compared by men, the rate of interest is affected positively or negatively. But for practical purposes the individual, counting for little in the midst of millions, must look upon the interest rate as beyond his influence. Therefore, while the rate is determined by each to some degree, all that any one does is to buy or sell present goods, borrow or lend capital, use up or save wealth, according as his own estimate of time-value is less or more than the market rate. In fact, the estimates of individuals diverge constantly from the market rate, but are brought into harmony by their actions with reference both to money loans and to the use and valuation of the various forms of wealth. A Robinson Crusoe working on his island and valuing future goods relatively to present goods higher than before, consumes less; or, valuing them lower, consumes more. The business man who values indirect agents above the market rate borrows, and if he miscalculates and fails to make them earn the expected rent, he loses. In this experimental way many other acts are influenced by the prevailing interest rate and in turn affect it, thus aiding to formulate society's estimate of the value of present as compared with future rents.