The General Theory of Employment, Interest and Money Part 4

III.

We have been dealing so far with a net increment of investment. If, therefore, we wish to apply the above without qualification to the effect of (e.g.) increased public works, we have to a.s.sume that there is no offset through decreased investment in other directions,?and also, of course, no a.s.sociated change in the propensity of the community to consume. Mr Kahn was mainly concerned in the article referred to above in considering what offsets we ought to take into account as likely to be important, and in suggesting quant.i.tative estimates. For in an actual case there are several factors besides some specific increase of investment of a given kind which enter into the final result. If, for example, a government employs 100,000 additional men on public works, and if the multiplier (as defined above) is 4, it is not safe to a.s.sume that aggregate employment will increase by 400,000. For the new policy may have adverse reactions on investment in other directions.

It would seem (following Mr Kahn) that the following are likely in a modern community to be the factors which it is most important not to overlook (though the first two will not be fully intelligible until after Book IV has been reached): (i) The method of financing the policy and the increased working cash, required by the increased employment and the a.s.sociated rise of prices, may have the effect of increasing the rate of interest and so r.e.t.a.r.ding investment in other directions, unless the monetary authority takes steps to the contrary; whilst, at the same time, the increased cost of capital goods will reduce their marginal efficiency to the private investor, and this will require an actual fall in the rate of interest to offset it.

(ii) With the confused psychology which often prevails, the government programme may, through its effect on 'confidence', increase liquidity-preference or diminish the marginal efficiency of capital, which, again, may r.e.t.a.r.d other investment unless measures are taken to offset it.

(iii) In an open system with foreign-trade relations, some part of the multiplier of the increased investment will accrue to the benefit of employment in foreign countries, since a proportion of the increased consumption will diminish our own country's favourable foreign balance; so that, if we consider only the effect on domestic employment as distinct from world employment, we must diminish the full figure of the multiplier. On the other hand our own country may recover a portion of this leakage through favourable repercussions due to the action of the multiplier in the foreign country in increasing its economic activity.

Furthermore, if we are considering changes of a substantial amount, we have to allow for a progressive change in the marginal propensity to consume, as the position of the margin is gradually shifted; and hence in the multiplier. The marginal propensity to consume is not constant for all levels of employment, and it is probable that there will be, as a rule, a tendency for it to diminish as employment increases; when real income increases, that is to say, the community will wish to consume a gradually diminishing proportion of it.

There are also other factors, over and above the operation of the general rule Just mentioned, which may operate to modify the marginal propensity to consume, and hence the multiplier; and these other factors seem likely, as a rule, to accentuate the tendency of the general rule rather than to offset jt. For, in the first place, the increase of employment will tend, owing to the effect of diminishing returns in the short period, to increase the proportion of aggregate income which accrues to the entrepreneurs, whose individual marginal propensity to consume is probably less than the average for the community as a whole. In the second place, unemployment is likely to be a.s.sociated with negative saving in certain quarters, private or public, because the unemployed may be living either on the savings of themselves and their friends or on public relief which is partly financed out of loans; with the result that re- employment will gradually diminish these particular acts of negative saving and reduce, therefore, the marginal propensity to consume more rapidly than would have occurred from an equal increase in the community's real income accruing in different circ.u.mstances.

In any case, the multiplier is likely to be greater for a small net increment of investment than for a large increment; so that, where substantial changes are in view, we must be guided by the average value of the multiplier based on the average marginal propensity to consume over the range in question.

Mr Kahn has examined the probable quant.i.tative result of such factors as these in certain hypothetical special cases. But, clearly, it is not possible to carry any generalisation very far. One can only say, for example, that a typical modern community would probably tend to consume not much less than 80 per cent of any increment of real income, if it were a closed system with the consumption of the unemployed paid for by transfers from the consumption of other consumers, so that the multiplier after allowing for offsets would not be much less than 5. In a country, however, where foreign trade accounts for, say, 20 per cent of consumption and where the unemployed receive out of loans or their equivalent up to, say, 50 per cent of their normal consumption when in work, the multiplier may fall as low as 2 or 3 times the employment provided by a specific new investment. Thus a given fluctuation of investment will be a.s.sociated with a much less violent fluctuation of employment in a country in which foreign trade plays a large part and unemployment relief is financed on a larger scale out of borrowing (as was the case, e.g. in Great Britain in 1931), than in a country in which these factors are less important (as in the United States in 1932). It is, however, to the general principle of the multiplier to which we have to look for an explanation of how fluctuations in the amount of investment, which are a comparatively small proportion of the national income, are capable of generating fluctuations in aggregate employment and income so much greater in amplitude than themselves.

IV.

The discussion has been carried on, so far, on the basis of a change in aggregate investment which has been foreseen sufficiently in advance for the consumption industries to advance pari pa.s.su with the capital-goods industries without more disturbance to the price of consumption-goods than is consequential, in conditions of decreasing returns, on an increase in the quant.i.ty which is produced.

In general, however, we have to take account of the case where the initiative comes from an increase in the output of the capital-goods industries which was not fully foreseen. It is obvious that an initiative of this description only produces its full effect on employment over a period of time. I have found, however, in discussion that this obvious fact often gives rise to some confusion between the logical theory of the multiplier, which holds good continuously, without time-lag, at all moments of time, and the consequences of an expansion in the capital-goods industries which take gradual effect, subject to time-lag and only after an interval.

The relationship between these two things can be cleared up by pointing out, firstly that an unforeseen, or imperfectly foreseen, expansion in the capital-goods industries does not have an instantaneous effect of equal amount on the aggregate of investment but causes a gradual increase of the latter; and, secondly, that it may cause a temporary departure of the marginal propensity to consume away from its normal value, followed, however, by a gradual return to it.

Thus an expansion in the capital-goods industries causes a series of increments in aggregate investment occurring in successive periods over an interval of time, and a series of values of the marginal propensity to consume in these successive periods which differ both from what the values would have been if the expansion had been foreseen and from what they will be when the community has settled down to a new steady level of aggregate investment. But in every interval of time the theory of the multiplier holds good in the sense that the increment of aggregate demand is equal to the product of the increment of aggregate investment and the multiplier as determined by the marginal propensity to consume.

The explanation of these two sets of facts can be seen most clearly by taking the extreme case where the expansion of employment in the capital-goods industries is so entirely unforeseen that in the first instance there is no increase whatever in the output of consumption-goods. In this event the efforts of those newly employed in the capital-goods industries to consume a proportion of their increased incomes will raise the prices of consumption-goods until a temporary equilibrium between demand and supply has been brought about partly by the high prices causing a postponement of consumption, partly by a redistribution of income in favour of the saving cla.s.ses as an effect of the increased profits resulting from the higher prices, and partly by the higher prices causing a depletion of stocks. So far as the balance is restored by a postponement of consumption there is a temporary reduction of the marginal propensity to consume, i.e. of the multiplier itself, and in so far as there is a depletion of stocks, aggregate investment increases for the time being by less than the increment of investment in the capital- goods industries,?i.e. the thing to be multiplied does not increase by the full increment of investment in the capital-goods industries. As time goes on, however, the consumption-goods industries adjust themselves to the new demand, so that when the deferred consumption is enjoyed, the marginal propensity to consume rises temporarily above its normal level, to compensate for the extent to which it previously fell below it, and eventually returns to its normal level; whilst the restoration of stocks to their previous figure causes the increment of aggregate investment to be temporarily greater than the increment of investment in the capital-goods industries (the increment of working capital corresponding to the greater output also having temporarily the same effect).

The fact that an unforeseen change only exercises its full effect on employment over a period of time is important in certain contexts;?in particular it plays a part in the a.n.a.lysis of the trade cycle (on lines such as I followed in my Treatise on Money). But it does not in any way affect the significance of the theory of the multiplier as set forth in this chapter; nor render it inapplicable as an indicator of the total benefit to employment to be expected from an expansion in the capital. goods industries. Moreover, except in conditions where the consumption industries are already working almost at capacity so that an expansion of output requires an expansion of plant and not merely the more intensive employment of the existing plant, there is no reason to suppose that more than a brief interval of time nced elapse before employment in the consumption industries is advancing pari pa.s.su with employment in the capital-goods industries with the multiplier operating near its normal figure.

V.

We have seen above that the greater the marginal propensity to consume, the greater the multiplier, and hence the greater the disturbance to employment corresponding to a given change in investment. This might seem to lead to the paradoxical conclusion that a poor community in which saving is a very small proportion of income will be more subject to violent fluctuations than a wealthy community where saving is a larger proportion of income and the multiplier consequently smaller.

This conclusion, however, would overlook the distinction between the effects of the marginal propensity to consume and those of the average propensity to consume. For whilst a high marginal propensity to consume involves a larger proportionate effect from a given percentage change in investment, the absolute effect will, nevertheless, be small if the average propensity to consume is also high. This may be ill.u.s.trated as follows by a numerical example.

Let us suppose that a community's propensity to consume is such that, so long as its real income does not exceed the output from employing 5,000,000 men on its existing capital equipment, it consumes the whole of its income; that of the output of the next 100,000 additional men employed it consumes 99 per cent, of the next 100,000 after that 98 per cent, of the third 100,000 97 per cent and so on; and that 10,000,000 men employed represents full employment. It follows from this that, when 5,000,000 + n 100,000 men are employed, the multiplier at the margin is 100/n, and [n(n + i)]/[2(50 + n)] per cent of the national income is invested.

Thus when 5,200,000 men are employed the multiplier is very large, namely 50, but investment is only a trifling proportion of current income, namely, 0.06 per cent; with the result that if investment falls off by a large proportion, say about two-thirds, employment will only decline to 5,100,000, i.e. by about 2 per cent. On the other hand, when 9,000,000 men are employed, the marginal multiplier is comparatively small, namely 2, but investment is now a substantial proportion of current income, namely, 9 per cent; with the result that if investment falls by two-thirds, employment will decline to 6,900,000, namely, by 19 per cent. In the limit where investment falls off to zero, employment will decline by about 4 per cent in the former case, whereas in the latter case it will decline by 44 per cent.

In the above example, the poorer of the two communities under comparison is poorer by reason of under- employment. But the same reasoning applies by easy adaptation if the poverty is due to inferior skill, technique or equipment. Thus whilst the multiplier is larger in a poor community, the effect on employment of fluctuations in investment will be much greater in a wealthy community, a.s.suming that in the latter current investment represents a much larger proportion of current output.

It is also obvious from the above that the employment of a given number of men on public works will (on the a.s.sumptions made) have a much larger effect on aggregate employment at a time when there is severe unemployment, than it will have later on when full employment is approached. In the above example, if, at a time when employment has fallen to 5,200,000, an additional 100,000 men are employed on public works, total employment will rise to 6,400,000. But if employment is already 9,000,000 when the additional 100,000 men are taken on for public works, total employment will only rise to 9,200,000. Thus public works even of doubtful utility may pay for themselves over and over again at a time of severe unemployment, if only from the diminished cost of relief expenditure, provided that we can a.s.sume that a smaller proportion of income is saved when unemployment is greater; but they may become a more doubtful proposition as a state of full employment is approached. Furthermore, if our a.s.sumption is correct that the marginal propensity to consume falls off steadily as we approach full employment, it follows that it will become more and more troublesome to secure a further given increase of employment by further increasing investment. It should not be difficult to compile a chart of the marginal propensity to consume at each stage of a trade cycle from the statistics (if they were available) of aggregate incorne and aggregate investment at successive dates. At present, however, our statistics are not accurate enough (or compiled sufficiently with this specific object in view) to allow us to infer more than highly approximate estimates. The best for the purpose, of which I am aware, are Mr Kuznets' figures for the United States (already referred to, p.103 above), though they are, nevertheless, very precarious. Taken in conjunction with estimates of national income these suggest, for what they are worth, both a lower figure and a more stable figure for the investment multiplier than I should have expected. If single years are taken in isolation, the results look rather wild. But if they are grouped in pairs, the multiplier seems to have been less than 3 and probably fairly stable in the neighbourhood of 2.5. This suggests a marginal propensity to consume not exceeding 6o to 70 per cent?a figure quite plausible for the boom, but surprisingly, and, in my judgment, improbably low for the slump. It is possible, however, that the extreme financial conservatism of corporate finance in the United States, even during the slump, may account for it. In other words, if, when investment is falling heavily through a failure to undertake repairs and replacements, financial provision is made, nevertheless, in respect of such wastage, the effect is to prevent the rise in the marginal propensity to consume which would have occurred otherwise. I suspect that this factor may have played a significant part in aggravating the degree of the recent slump in the United States. On the other hand, it is possible that the statistics somewhat overstate the decline in investment, which is alleged to have fallen off by more than 75 per cent in 1932 compared with 1929, whilst net 'capital formation' declined by more than 95 per cent;?a moderate change in these estimates being capable of making a substantial difference to the multiplier.

VI.

When involuntary unemployment exists, the marginal disutility of labour is necessarily less than the utility of the marginal product. Indeed it may be much less. For a man who has been long unemployed some measure of labour, instead of involving disutility, may have a positive utility. If this is accepted, the above reasoning shows how 'wasteful' loan expenditure may nevertheless enrich the community on balance. Pyramid-building, earthquakes, even wars may serve to increase wealth, if the education of our statesmen on the principles of the cla.s.sical economics stands in the way of anything better.

It is curious how common sense, wriggling for an escape from absurd conclusions, has been apt to reach a preference for wholly 'wasteful' forms of loan expenditure rather than for partly wasteful forms, which, because they are not wholly wasteful, tend to be judged on strict 'business' principles. For example, unemployment relief financed by loans is more readily accepted than the financing of improvements at a charge below the current rate of interest; whilst the form of digging holes in the ground known as gold-mining, which not only adds nothing whatever to the real wealth of the world but involves the disutility of labour, is the most acceptable of all solutions.

If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coalmines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again (the right to do so being obtained, of course, by tendering for leases of the note-bearing territory), there need be no more unemployment and, with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is. It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing.

The a.n.a.logy between this expedient and the goldmines of the real world is complete. At periods when gold is available at suitable depths experience shows that the real wealth of the world increases rapidly; and when but little of it is so available our wealth suffers stagnation or decline. Thus gold-mines are of the greatest value and importance to civilisation. Just as wars have been the only form of large-scale loan expenditure which statesmen have thought justifiable, so gold-mining is the only pretext for digging holes in the ground which has recommended itself to bankers as sound finance; and each of these activities has played its part in progress?failing something better. To mention a detail, the tendency in slumps for the price of gold to rise in terms of labour and materials aids eventual recovery, because it increases the depth at which gold-digging pays and lowers the minimum grade of ore which is payable.

In addition to the probable effect of increased supplies of gold on the rate of interest, gold-mining is for two reasons a highly practical form of investment, if we are precluded from increasing employment by means which at the same time increase our stock of useful wealth. In the first place, owing to the gambling attractions which it offers it is carried on without too close a regard to the ruling rate of interest. In the second place the result, namely, the increased stock of gold, does not, as in other cases, have the effect of diminishing its marginal utility. Since the value of a house depends on its utility, every house which is built serves to diminish the prospective rents obtainable from further house- building and therefore lessens the attraction of further similar investment unless the rate of interest is falling pari pa.s.su. But the fruits of gold-mining do not suffer from this disadvantage, and a check can only come through a rise of the wage-unit in terms of gold, which is not likely to occur unless and until employment is substantially better. Moreover, there is no subsequent reverse effect on account of provision for user and supplementary costs, as in the case of less durable forms of wealth.

Ancient Egypt was doubly fortunate, and doubtless owed to this its fabled wealth, in that it possessed two activities, namely, pyramid-building as well as the search for the precious metals, the fruits of which, since they could not serve the needs of man by being consumed, did not stale with abundance.

The Middle Ages built cathedrals and sang dirges. Two pyramids, two ma.s.ses for the dead, are twice as good as one; but not so two railways from London to York. Thus we are so sensible, have schooled ourselves to so close a semblance of prudent financiers, taking careful thought before we add to the 'financial' burdens of posterity by building them houses to live in, that we have no such easy escape from the sufferings of unemployment. We have to accept them as an inevitable result of applying to the conduct of the State the maxims which are best calculated to 'enrich' an individual by enabling him to pile up claims to enjoyment which he does not intend to exercise at any definite time.

Chapter 11.

THE MARGINAL EFFICIENCY OF CAPITAL.

I.

When a man buys an investment or capital-a.s.set, he purchases the right to the series of prospective returns, which he expects to obtain from selling its output, after deducting the running expenses of obtaining that output, during the life of the a.s.set. This series of annuities Q

1.

, Q.

2.

, . . . Q.

n it is convenient to call the prospective yield of the investment.

Over against the prospective yield of the investment we have the supply price of the capital-a.s.set, meaning by this, not the market-price at which an a.s.set of the type in question can actually be purchased in the market, but the price which would just induce a manufacturer newly to produce an additional unit of such a.s.sets, i.e. what is sometimes called its replacement cost . The relation between the prospective yield of a capital-a.s.set and its supply price or replacement cost, i.e. the relation between the prospective yield of one more unit of that type of capital and the cost of producing that unit, furnishes us with the marginal efficiency of capital of that type. More precisely, I define the marginal efficiency of capital as being equal to that rate of discount which would make the present value of the series of annuities given by the returns expected from the capital-a.s.set during its life just equal to its supply price. This gives us the marginal efficiencies of particular types of capital-a.s.sets. The greatest of these marginal efficiencies can then be regarded as the marginal efficiency of capital in general.

The reader should note that the marginal efficiency of capital is here defined in terms of the expectation of yield and of the current supply price of the capital-a.s.set. It depends on the rate of return expected to be obtainable on money if it were invested in a newly produced a.s.set; not on the historical result of what an investment has yielded on its original cost if we look back on its record after its life is over.

If there is an increased investment in any given type of capital during any period of time, the marginal efficiency of that type of capital will diminish as the investment in it is increased, partly because the prospective yield will fall as the supply of that type of capital is increased, and partly because, as a rule, pressure on the facilities for producing that type of capital will cause its supply price to increase; the second of these factors being usually the more important in producing equilibrium in the short run, but the longer the period in view the more does the first factor take its place. Thus for each type of capital we can build up a schedule, showing by how much investment in it will have to increase within the period, in order that its marginal efficiency should fall to any given figure. We can then aggregate these schedules for all the different types of capital, so as to provide a schedule relating the rate of aggregate investment to the corresponding marginal efficiency of capital in general which that rate of investment will establish. We shall call this the investment demand-schedule; or, alternatively, the schedule of the marginal efficiency of capital.

Now it is obvious that the actual rate of current investment will be pushed to the point where there is no longer any cla.s.s of capital-a.s.set of which the marginal efficiency exceeds the current rate of interest. In other words, the rate of investment will be pushed to the point on the investment demand-schedule where the marginal efficiency of capital in general is equal to the market rate of interest.

The same thing can also be expressed as follows. If Q r is the prospective yield from an a.s.set at time r , and d r is the present value of 1 deferred r years at the current rate of interest, ? Q r d r is the demand price of the investment; and investment will be carried to the point where ? Q r d r becomes equal to the supply price of the investment as defined above. If, on the other hand, ? Q r d r falls short of the supply price, there will be no current investment in the a.s.set in question.

It follows that the inducement to invest depends partly on the investment demand-schedule and partly on the rate of interest. Only at the conclusion of Book IV will it be possible to take a comprehensive view of the factors determining the rate of investment in their actual complexity. I would, however, ask the reader to note at once that neither the knowledge of an a.s.set's prospective yield nor the knowledge of the marginal efficiency of the a.s.set enables us to deduce either the rate of interest or the present value of the a.s.set. We must ascertain the rate of interest from some other source, and only then can we value the a.s.set by 'capitalising' its prospective yield.

II.

How is the above definition of the marginal efficiency of capital related to common usage? The Marginal Productivity or Yield or Efficiency or Utility of Capital are familiar terms which we have all frequently used. But it is not easy by searching the literature of economics to find a clear statement of what economists have usually intended by these terms.

There are at least three ambiguities to clear up. There is, to begin with, the ambiguity whether we are concerned with the increment of physical product per unit of time due to the employment of one more physical unit of capital, or with the increment of value due to the employment of one more value unit of capital. The former involves difficulties as to the definition of the physical unit of capital, which I believe to be both insoluble and unnecessary. It is, of course, possible to say that ten labourers will raise more wheat from a given area when they are in a position to make use of certain additional machines; but I know no means of reducing this to an intelligible arithmetical ratio which does not bring in values.

Nevertheless many discussions of this subject seem to be mainly concerned with the physical productivity of capital in some sense, though the writers fail to make themselves clear.

Secondly, there is the question whether the marginal efficiency of capital is some absolute quant.i.ty or a ratio. The contexts in which it is used and the practice of treating it as being of the same dimension as the rate of interest seem to require that it should be a ratio. Yet it is not usually made clear what the two terms of the ratio are supposed to be.

Finally, there is the distinction, the neglect of which has been the main cause of confusion and misunderstanding, between the increment of value obtainable by using an additional quant.i.ty of capital in the existing situation, and the series of increments which it is expected to obtain over the whole life of the additional capital a.s.set; ? i.e. the distinction between Q

1.

and the complete series Q

1.

, Q.

2.

, . . . Q.

r , . . . .This involves the whole question of the place of expectation in economic theory. Most discussions of the marginal efficiency of capital seem to pay no attention to any member of the series except Q

1.

. Yet this cannot be legitimate except in a Static theory, for which all the Q 's are equal. The ordinary theory of distribution, where it is a.s.sumed that capital is getting now its marginal productivity (in some sense or other), is only valid in a stationary state. The aggregate current return to capital has no direct relationship to its marginal efficiency; whilst its current return at the margin of production (i.e.

the return to capital which enters into the supply price of output) is its marginal user cost, which also has no close connection with its marginal efficiency.

There is, as I have said above, a remarkable lack of any clear account of the matter. At the same time I believe that the definition which I have given above is fairly close to what Marshall intended to mean by the term. The phrase which Marshall himself uses is 'marginal net efficiency' of a factor of production; or, alternatively, the 'marginal utility of capital'. The following is a summary of the most relevant pa.s.sage which I can find in his Principles (6th ed. pp. 519 ? 520). I have run together some non- consecutive sentences to convey the gist of what he says: In a certain factory an extra 100 worth of machinery can be applied so as not to involve any other extra expense, and so as to add annually 3 worth to the net output of the factory after allowing for its own wear and tear. If the investors of capital push it into every occupation in which it seems likely to gain a high reward; and if, after this has been done and equilibrium has been found, it still pays and only just pays to employ this machinery, we can infer from this fact that the yearly rate of interest is 3 per cent.

But ill.u.s.trations of this kind merely indicate part of the action of the great causes which govern value.

They cannot be made into a theory of interest, any more than into a theory of wages, without reasoning in a circle. . . Suppose that the rate of interest is 3 per cent. per annum on perfectly good security; and that the hat-making trade absorbs a capital of one million pounds. This implies that the hat-making trade can turn the whole million pounds' worth of capital to so good account that they would pay 3 per cent.

per annum net for the use of it rather than go without any of it. There may be machinery which the trade would have refused to dispense with if the rate of interest had been 20 per cent. per annum. If the rate had been 10 per cent., more would have been used; if it had been 6 per cent., still more; if 4 per cent.

still more; and finally, the rate being 3 per cent., they use more still. When they have this amount, the marginal utility of the machinery, i.e. the utility of that machinery which it is only just worth their while to employ, is measured by 3 per cent.

It is evident from the above that Marshall was well aware that we are involved in a circular argument if we try to determine along these lines what the rate of interest actually is. In this pa.s.sage he appears to accept the view set forth above, that the rate of interest determines the point to which new investment will be pushed, given the schedule of the marginal efficiency of capital. If the rate of interest is 3 per cent, this means that no one will pay 100 for a machine unless he hopes thereby to add 3 to his annual net output after allowing for costs and depreciation. But we shall see in chapter 14 that in other pa.s.sages Marshall was less cautious ? though still drawing back when his argument was leading him on to dubious ground.

Although he does not call it the 'marginal efficiency of capital', Professor Irving Fisher has given in his Theory of Interest (1930) a definition of what he calls 'the rate of return over cost' which is identical with my definition. 'The rate of return over cost', he writes, 'is that rate which, employed in computing the present worth of all the costs and the present worth of all the returns, will make these two equal.'

Professor Fisher explains that the extent of investment in any direction will depend on a comparison between the rate of return over cost and the rate of interest. To induce new investment 'the rate of return over cost must exceed the rate of interest'. 'This new magnitude (or factor) in our study plays the central role on the investment opportunity side of interest theory.' Thus Professor Fisher uses his 'rate of return over cost in the same sense and for precisely the same purpose as I employ 'the marginal efficiency of capital'.

III.

The most important confusion concerning the meaning and significance of the marginal efficiency of capital has ensued on the failure to see that it depends on the prospective yield of capital, and not merely on its current yield. This can be best ill.u.s.trated by pointing out the effect on the marginal efficiency of capital of an expectation of changes in the prospective cost of production, whether these changes are expected to come from changes in labour cost, i.e. in the wage-unit, or from inventions and new technique. The output from equipment produced to-day will have to compete, in the course of its life, with the output from equipment produced subsequently, perhaps at a lower labour cost, perhaps by an improved technique, which is content with a lower price for its output and will be increased in quant.i.ty until the price of its output has fallen to the lower figure with which it is content. Moreover, the entrepreneur's profit (in terms of money) from equipment, old or new, will be reduced, if all output comes to be produced more cheaply. In so far as such developments are foreseen as probable, or even as possible, the marginal efficiency of capital produced to-day is appropriately diminished.

This is the factor through which the expectation of changes in the value of money influences the volume of current output. The expectation of a fall in the value of money stimulates investment, and hence employment generally, because it raises the schedule of the marginal efficiency of capital, i.e. the investment demand-schedule; and the expectation of a rise in the value of money is depressing, because it lowers the schedule of the marginal efficiency of capital.

This is the truth which lies behind Professor Irving Fisher's theory of what he originally called 'Appreciation and Interest' ? the distinction between the money rate of interest and the real rate of interest where the latter is equal to the former after correction for changes in the value of money. It is difficult to make sense of this theory as stated, because it is not clear whether the change in the value of money is or is not a.s.sumed to be foreseen. There is no escape from the dilemma that, if it is not foreseen, there will be no effect on current affairs; whilst, if it is foreseen, the prices of existing goods will be forthwith so adjusted that the advantages of holding money and of holding goods are again equalised, and it will be too late for holders of money to gain or to suffer a change in the rate of interest which will offset the prospective change during the period of the loan in the value of the money lent.

For the dilemma is not successfully escaped by Professor Pigou's expedient of supposing that the prospective change in the value of money is foreseen by one set of people but not foreseen by another.

The mistake lies in supposing that it is the rate of interest on which prospective changes in the value of money will directly react, instead of the marginal efficiency of a given stock of capital. The prices of existing a.s.sets will always adjust themselves to changes in expectation concerning the prospective value of money. The significance of such changes in expectation lies in their effect on the readiness to produce new a.s.sets through their reaction on the marginal efficiency of capital. The stimulating effect of the expectation of higher prices is due, not to its raising the rate of interest (that would be a paradoxical way of stimulating output ? in so far as the rate of interest rises, the stimulating effect is to that extent offset), but to its raising the marginal efficiency of a given stock of capital. If the rate of interest were to rise pari pa.s.su with the marginal efficiency of capital, there would be no stimulating effect from the expectation of rising prices. For the stimulus to output depends on the marginal efficiency of a given stock of capital rising relatively to the rate of interest. Indeed Professor Fisher's theory could be best re- written in terms of a 'real rate of interest' defined as being the rate of interest which would have to rule, consequently on a change in the state of expectation as to the future value of money, in order that this change should have no effect on current output. It is worth noting that an expectation of a future fall in the rate of interest will have the effect of lowering the schedule of the marginal efficiency of capital; since it means that the output from equipment produced to-day will have to compete during part of its life with the output from equipment which is content with a lower return. This expectation will have no great depressing effect, since the expectations, which are held concerning the complex of rates of interest for various terms which will rule in the future, will be partially reflected in the complex of rates of interest which rule to-day. Nevertheless there may be some depressing effect, since the output from equipment produced to-day, which will emerge towards the end of the life of this equipment, may have to compete with the output of much younger equipment which is content with a lower return because of the lower rate of interest which rules for periods subsequent to the end of the life of equipment produced to-day. It is important to understand the dependence of the marginal efficiency of a given stock of capital on changes in expectation, because it is chiefly this dependence which renders the marginal efficiency of capital subject to the somewhat violent fluctuations which are the explanation of the trade cycle. In chapter 22 below we shall show that the succession of boom and slump can be described and a.n.a.lysed in terms of the fluctuations of the marginal efficiency of capital relatively to the rate of interest.