The first three plates asked why a price of time exists at all — the discount, the impatience that will not wait, the productivity of the detour that makes waiting bear fruit. This plate, and the two that follow, ask a different question: not why interest exists, but how its level is fixed. And it begins with the classical answer, the most natural one — that the rate of interest is a price like any other, set in a market, by supply and demand. The market is the market for loanable funds, the funds available to be lent and borrowed; the supply is saving, the demand is investment; and the rate is the price that clears the market, brought to rest where the amount people wish to save just equals the amount that firms wish to invest. The two springs of the foundational plates meet here as a market: impatience, which governs the supply of saving, and productivity, which governs the demand for investment, are reconciled at a single price. This plate will set the theory out in its strength — the rate as the coordinator of present and future, the signal that channels a society's thrift into its productive capacity — and then mark the great challenge it faces: that the rate may be set not in the market for saving at all, but in the market for money.
Begin with the market itself. There are those who have income they do not wish to consume now — savers — and they supply their unspent funds to be lent. There are those who wish to command resources they do not now possess — borrowers, and above all the firms that would invest in the productive detour — and they demand funds to borrow. Between them stands a price: the rate of interest, what the borrower pays and the saver receives for the use of funds across time. And like any price, it is governed by the two blades. The supply of funds, saving, rises with the rate: the more interest offered for deferring consumption, the more, in the main, people will defer, and so the supply curve climbs. The demand for funds, investment, falls with the rate: the higher the cost of borrowing, the fewer the productive projects whose return can clear it, and so the demand curve descends. Where the rising supply meets the falling demand, the market clears — a single rate at which the funds the savers wish to lend exactly equal the funds the borrowers wish to take. That clearing rate is the loanable-funds theory's answer to the question of how interest is fixed.
And here the foundational plates are gathered into the market. For the supply of saving is nothing but impatience made visible: the willingness to defer that the plate on impatience anatomized is exactly what fixes how much a people will save at each rate — the less impatient the society, the more it saves at any given rate, the further to the right its supply curve stands. And the demand for investment is nothing but the productivity of the detour made visible: the marginal product of capital that the plate on the roundabout examined is exactly what fixes how much firms will borrow to invest at each rate — the more productive the detours on offer, the more they will invest at any given rate, the further to the right their demand curve stands. So the market for loanable funds is the Fisherian synthesis given a price: impatience supplies, productivity demands, and the rate is struck where the marginal impatience of the savers is brought level with the marginal productivity of the investment — the very equality the plate on the roundabout reached, drawn now as the crossing of two curves in a market for funds. The rate that clears the market is the rate that reconciles a society's thrift with its opportunities.
Impatience supplies, productivity demands; and the rate is struck where the two of them are brought level.
The classical economists saw in this clearing rate something more than a price: a governor, the mechanism by which an economy allocates itself between the present and the future. A high rate discourages the borrower and rewards the saver, turning a society toward thrift and away from present spending; a low rate does the reverse. Let a people grow more thrifty, and let the supply of saving swell — the rate falls, and the cheaper funds call forth more investment, so that the extra thrift is turned, by the fall in the rate, into extra productive capacity for the future. Let new and richer opportunities for investment appear, and let the demand for funds swell — the rate rises, and the higher reward calls forth more saving, so that the new opportunities are met by extra deferral. The rate, on this view, is the supple coordinator of present and future: whatever a society's thrift and whatever its opportunities, the rate moves to reconcile them, and — here is the classical confidence — to ensure that no saving lies idle, that every coin withheld from consumption finds its way, through the fall in the rate it induces, into investment. Saving and investment are held equal by the rate; and so the future is provided for, quietly and of itself.
But this confident theory met, in the last century, a challenge that shook it, and the plate must give the challenge its due, though its full force belongs to the next. Keynes denied that the rate is set in the market for saving at all. The rate, he argued, is a monetary thing — the price of parting with money, of holding one's wealth in bonds rather than in cash — and is fixed not by thrift and productivity but by the quantity of money and the public's desire to hold it. And from this followed a graver doubt. If the rate is not the price that clears the saving-investment market, then nothing guarantees that saving will equal investment at full employment. Let a people grow more thrifty, and the classical theory promises that the rate will fall and investment rise to absorb the extra saving; but Keynes argued that the rate might not fall as it must, and that the extra saving, finding no answering investment, would instead pull down income — that the attempt to save more would, by cutting spending, cut output and employment until saving was dragged back into equality with investment at a lower level of activity, the very savings the society had meant to make destroyed by the impoverishment its thrift had brought on. This is the paradox of thrift, and it is the exact antithesis of the classical confidence: where the loanable-funds theory saw the rate quietly turning thrift into capacity, Keynes saw thrift, ungoverned by a rate that would not move, turning into slump.
The quarrel between the two theories — the rate as the price of funds, the rate as the price of money — was among the fiercest in the science, and its resolution was a kind of peace treaty. It was shown that the two are not so much rivals as halves: that the rate of interest and the level of income are settled together, by the real side and the monetary side at once. The real side — the saving-and-investment relation of the loanable-funds theory — fixes, for each possible rate, the level of income at which saving would equal investment; the monetary side — the liquidity preference of Keynes — fixes, for each possible income, the rate at which the public is content to hold the money in existence; and only where the two are jointly satisfied is the economy at rest, with the rate and the income determined at one stroke. On this settlement the loanable-funds theory is not wrong but partial: it gives the real forces, thrift and productivity, that press upon the rate, but it cannot fix the rate alone, for the rate hangs also upon money and income, which the theory quietly holds fixed in the background. The classical theory tells the truth about the supply of saving and the demand for investment; it does not tell the whole truth about the rate, because the rate is not theirs alone to set.
The classical theory tells the truth about the supply of saving and the demand for investment; it does not tell the whole truth about the rate, because the rate is not theirs alone to set.
What, then, does the loanable-funds theory say to the volume's question — whether the price of time is earned or extracted? It says, in its way, the most reassuring thing any theory in this volume says: that the rate is a competitive price, set by no one, emerging from the impersonal meeting of many savers and many borrowers, as the price of wheat emerges from the meeting of many farmers and many bakers. And a competitive price has a kind of innocence: it is not imposed by the strong upon the weak but discovered by the market, the equilibrium reward of thrift and the equilibrium cost of opportunity, owed to no one's will. If interest is merely this — the price that clears the market for funds — then it is as earned, and as little extracted, as any competitive price can be. But the reassurance is conditional, and the conditions are just where the volume's question creeps back in. It holds only if the market is genuinely competitive — and the market for funds is one that a few great banks, and one central bank above all, can move, as a later plate will show, so that the rate may be less the verdict of competition than the decision of an authority. It holds only if the saving and the investment whose meeting sets the rate are themselves fairly grounded — and the plates on impatience and the roundabout showed that they need not be, the saving perhaps a desperate necessity, the investment perhaps a harvest of labour it did not perform. And it holds only if the rate truly clears the market — which Keynes denied. The same question that the wage volume put to the price of labour in its opening plate — competitive price, or the moved hand of power? — the loanable-funds theory invites and cannot, of itself, close: a competitive price is the most earned thing in economics, but whether any actual rate is that competitive price, struck in a free market upon fair foundations, is precisely what the theory assumes and what it cannot prove.
So the loanable-funds theory gives the first answer to how the rate is fixed: it is the price that clears the market for funds, the meeting of saving and investment, of impatience and productivity drawn at last as supply and demand. It is the most intuitive of the theories and, on its own terms, the most exonerating — a competitive price, owed to no one, the impersonal reconciliation of a society's thrift with its opportunities. But the plate has had to enter two reservations, and they will govern the plates to come. The first is that the rate may not be the market for funds' to set — that money, and the desire to hold it, may have the larger hand, as the next plate will argue. The second is that even a competitive clearing-rate inherits the questions of its foundations — that the innocence of the market price is only as deep as the fairness of the saving and the investment it equates. The rate that clears the market for the future is real, and the coordination it performs is real; but whether it is the free verdict of competition or the moved hand of an authority, and whether the future it provides for is provided for justly, are questions the market diagram cannot answer of itself. How money bends the rate, the next plate takes up; how an authority sets it, a later one; and through all of them, as the table says of every price, the argument remains open.