Econ 1, Foldvary
Mankiw, Chapter 18: Market for the Factors of Production
Interest, capital goods, land.
What is interest?
Superficially, it is a payment for the use of money.
But what is it really, and why should anyone pay it?
If the interest rate were zero, the quantity demanded for loanable funds would be greater than the quantity supplied. Why?
Because of time preference:
The general tendency of most people most of the time to prefer goods at the present time to goods in the future. .
Most folks prefer to have goods at the present time than in the future.
Would you rather have a $1000 certificate to buy goods you want, today, or 30 years from now?
Most want it today because of the limited lifespan and the uncertainty of the future.
Therefore, the price of goods in the future is lower than that of goods in the present.
Goods in the future have a discount.
The rate of discount is the interest rate. It determines the natural or free-market rate of interest.
The paid rate of interest can differ from the natural rate if there is a temporary increase in the money supply that increases the supply of loanable funds and temporarily drives down the interest rate.
The nominal interest rate is the rate quoted by a financial institution and the money paid divided by the principal.
But part of that payment is just to make up for an increase in the level of prices.
The real interest rate is the nominal rate minus the inflation rate.
An important role of the interest rate is to equilibrate savings and economic investment.
An economic investment is an increase in the stock of capital goods or in human capital.
(This is a different meaning than a personal financial investment in, say, bonds.)
What if the amount investors want to borrow is more than the amount households want to save?
The nominal interest rate is also affected by taxes.
There is also a risk premium in addition to the real interest rate, for higher risk.
Some of the "interest" paid by a borrower pays for the overhead expense.
Interest on credit-card debt is high because most of it is not real interest but overhead, and a risk premium, payments for bad debts.
Lenient bankruptcy laws are an intervention that allows borrowers to cancel their debts, which increases the cost of borrowing for everyone else.
The three factors: land, labor, capital goods.
What factor is interest a return to?
Interest can be a return to any factor.
Mankiw says "capital" is the "stock of equipment and structures used for production."
"Capital" in economics has two meanings:
1) financial capital: funds such as money, or claims such as bonds.
Capital goods are goods which have been produced but not yet consumed.
Capital goods increase the power of labor to produce wealth.
Higher-order capital goods take longer to mature into profit, such as trees that take longer to grow. If a capital good takes longer to become profitable, its rate of return is lower if its price at maturity is the same as that of a lower-order good.
An investment is therefore profitable only if its rate of return is not lower than the interest rate.
When the interest rate falls, it becomes more profitable to invest in higher-order capital goods.
When the central bank increases the money supply rapidly, the interest rate falls, and there is more investment in higher-order capital goods.
But these become unprofitable later, as prices rise, and become wasted.
Inflation therefore does not just increase prices but also distorts the structure of capital goods and wastes the investments.
Land includes all natural resources.
The term land embraces all natural materials, forces, and opportunities.
It includes material land such as oil and minerals in the ground, and three-dimensional space.
As soon as oil is take out of the ground and put in a pipeline, it ceases to be land and becomes a capital good. But space never gets transformed and remains spatial land.
Space cannot be increased; filling in water just changes the materials within that space.
The supply of space is fixed, totally inelastic.
The return or yield of land is "rent".
Can you improve land? No.
Any improvements are capital goods.
The landowner, qua (only as) landowner, does nothing in return for the rent, since the land is provided by nature. The rent is a surplus, derived only from scarcity and demand.
The demand for a factor is based on its marginal productivity.
Factors are hired or rented up to the quantity for which the marginal product equals the rental.
The market price of an asset is its capitalized return:
p=r/i, price equals rental divided by the real interest rate.
In the case of land, if there is a tax rate t based on the price p, then if the future rent r is not expected to change,
p = r / (i+t)
A tax on the land value or rent becomes capitalized into a lower price of land.
So there is no tax burden on a new buyer, because the tax is offset by the lower price of land and lower mortgage interest payment.
The fraction of the rent being taxed is t*p/r, since the tax paid is the tax rate t times the price.
Since p=r/(i+t), the fraction is tr/[(i+t)r] = t/(i+t)
So if i=.04 and t=.06, the fraction of rent taxes is .06/.10 = 60%.