Money in an open economy 265

The devaluation automatically raises the domestic price level, which creates
an excess demand for money and hence the payments surplus. On the other
hand, we have argued on pages 2456 above that the payments surplus resulting
from the devaluation may be part of the process that creates an excess supply
of money, with its inflationary consequences.
A similar story applies to the case of imported inflation. The strong version
of the MABP completely neglects the monetary channel of imported inflation.
Instead, it focuses solely on the direct-price-transmission channel. As in the
case of devaluation, it is higher prices (imported from abroad) that cause an
excess demand for money and hence a payments surplus. We conjecture that
it is the failure to recognize that massive surpluses were imposed on countries
in 1971 and again in 1973 that led to widespread misdiagnoses of the
breakdown of the Bretton Woods system and of the acceleration of worldwide
inflation that followed (see Rabin, 1977; Rabin and Yeager, 1982 and pages
25860 above).
Advocates of the strong version of the MABP believe that the domestic
money supply is always demand-determined. They thus commit the same
errors as those economists who argue that when the monetary authority pursues
interest rate targeting, the money supply is always demand-determined (see
pages 11820 above).
The strong version of the MAXR is analogous to the strong version of the
MABP. It too is a theory that happens not to be generally valid. It unequivocally
associates a currencys depreciation on the foreign exchange market with an
excess supply of money and an appreciation with an excess demand for money.
While these associations may be typical, they are not necessary. Rabin and
Yeager (1982) provide counterexamples to the strong version of the MAXR as
well as to the strong version of the MABP. (In several of his articles and in his
book of 2002, Norman C. Miller also recognizes the errors of the strong
versions.)

NOTES
1. This definition accords with the official-reserve-transactions (ORT) concept.
2. See Yeager (1976b, pp. 6512) for a full discussion of these points. Dorn (1999, p. 314)
recogizes the argument presented here. Kenen (2000, p. 113) notes that a system of stable but
adjustable exchange rates is an oxymoron, since stability is incompatible with adjustability.
3. Yeager (1976b) documents Germanys struggle against imported inflation from the early
1950s until the systems demise.
4. The international currency crises of the 1990s have spawned an enormous literature. Flood
and Marion (1998) present a technical review of this research, some of which dates back to
the early 1980s.
5. Under the Bretton Woods system, rate fluctuations of one percent on either side of the peg
were allowed, but in reality they were usually held to 0.75 percent. The Smithsonian agreement
of 1971 widened the permissible range to 2.25 percent on either side.
266 Monetary theory

6. Triffin (1966) diagnoses the contradictions inherent in the system, especially the conflict
between the liquidity and confidence problems.
7. Meiselman (1975, p. 72) correctly identifies the system as an engine of worldwide inflation.
8. Greenfield (1994, p. 69) also recognizes this point
9. Friedman (1999, p. 140) attributes the variability in exchange rates to the wider variability in
inflation rates among countries. He views this exchange rate variability as a necessary
reaction, maybe over-reaction, to what was going on. He points out that trying to maintain
fixed rates under these conditions would have posed major problems.
10. Flood and Marion (1998, p. 41) argue that not only exchange rate models, but all asset-price
models based on underlying fundamentals work poorly. Taylor (1995) reviews the literature
on exchange rates and notes that most models cannot forecast better than the random walk.
10. Interest rate theory

This chapter views the interest rate, broadly interpreted, as basically a real
phenomenon and addresses the following two questions. What factors determine
the interest rate? What functions does it perform in a market economy? While
it is convenient to speak of the interest rate as well as of the wage rate, we
recognize that in reality no single rate of either kind prevails. Yeager (1994b)
cites the contributions of the following to interest rate theory: Allais (1947),
Bhm-Bawerk (1959), Cassell (1903 [1956]), Eucken (1954), Fisher (1930
[1955]), Hirshleifer (1970) and Wicksell (1934).

INTEREST AS A FACTOR PRICE

We can simplify capital and interest theory, tie it in better with general micro
theory, and clear up certain puzzles by resurrecting the view that the interest rate
is the price of waiting, a factor of production. Waiting is the service performed
by holding financial and physical assets instead of selling them and devoting
the proceeds to current consumption or to other current exercise of command
over resources. Waiting has the dimensions of value over time. We do not claim
that this view of the interest rate is the only valid one. We invoke the distinc-
tion made in Chapters 1 and 9 between an approach and theory. The approach
we take here is compatible with other approaches to the interest rate (for
example, compare Chapter 2).
A.R.J. Turgot noted over two centuries ago that the interest rate is the price
given for the use of a certain quantity of value during a certain time. He put
this use on a par with other factors of production.1 Cassel (1903 [1956], p. 67)
regarded it as settled, once and for all, that interest is the price paid for an inde-
pendent and elementary factor of production which may be called either waiting
or use of capital, according to the point of view from which it is looked at.
Dorfman (1959, pp. 367, 370) reaffirmed the reality of waiting as one of the
primary factors of production, co-ordinate with labor, land, etc...[W]aiting is a
genuine scarce factor of production...The unit of waiting [may be taken as] one
unit of consumption deferred for one unit of time.2
Waiting so conceived enables the person demanding or acquiring it to devote
productive resources to his own purposes sooner or on a larger scale than he
otherwise could; he obtains advanced availability. The person who supplies or

267
268 Monetary theory

performs waiting postpones the use for his own purposes of resources over
which he could have exercised current command.
Some economists old and recent, even including Irving Fisher, have denied
that waiting is a distinct productive factor, apparently not seeing that the
supposed issue is spurious. Actually, it is idle to argue over whether the thing
whose price is the interest rate is or is not really a productive factor. What to
count as inputs into a production function, and just how to conceive of the
production function itself, is a matter of convenience in each particular context
(see pages 412 above). In some contexts it is convenient to regard machines,
buildings and other capital goods, or their services, as factors of production
and not to probe more deeply or theorize more abstractly. In other contexts,
particularly those concerned with what the interest rate is a payment for and
what its functions are, it is helpful to regard it as a factor price and probe into
the factors nature.
To interpret capital as waiting gives intelligible meaning to such familiar
phrases as interest on capital, the cost of capital, the capital market,
shortage of capital, and international capital movements. It helps us bypass
the supposed need to distinguish between goods that do and goods that do not
properly count as physical capital. It enlists familiar concepts of supply, demand
and derived demand. It figures in explaining how international trade in goods
can tend to equalize interest rates internationally like other factor prices. It
permits handling the odd case of a negative interest rate. It helps show what
sort of opportunity cost the interest rate measures and, more generally, provides
deeper understanding of the logic of a price system by applying that logic to a
challenging phenomenon.
In some respects waiting is an unfortunate term. It does not describe the
service bought and sold equally well from both the buyers and sellers points
of view. The buyer of the service, such as a borrower, is not acquiring waiting
but avoiding it; he is paying someone else to do waiting for him. But the term
labor runs into similar embarrassments. The buyer is not performing labor
but paying someone else to perform it for him. Despite what the term suggests,
labor like waiting is not always irksome.
Waiting can be supplied or performed and demanded or avoided in many
ways besides granting and obtaining loans. Competition, substitution, and
arbitrage tend to make waiting performed by lending, by holding an investment
in capital goods or in land, and by acting in other ways all bear the same net
rate of return with obvious qualifications about risk, liquidity and the like.
(Compare the portfolio-balance condition for equilibrium in Chapter 2.)
Consider business firms deciding whether to buy automobiles or rent them.
The higher the interest rate on loans in relation to rental charges, the less firms
will borrow to buy cars and the more they will rent them. Their doing so will
tend to reduce loan rates and increase rates of return in the car rental business.
 Interest rate theory 269

Conversely, the lower the loan rate in relation to rental charges, the greater the
borrowing to buy cars and the less the volume of renting, again tending to bring
the interest rate on loans and rental charges in relation to the values of cars into
an equilibrium relation.
One methodological point is worth mentioning. How changes in wants,
resources, or technology affect such price relations should be explainable in
terms of the explicit interest rate determined on the loan market and of substi-
tution and arbitrage between loans and other forms in which people supply and
demand waiting. This precept warns against forgetting the literal and narrow
definition of the interest rate as the price of loans. (We have argued throughout
this book that the interest rate is not the price of money.)
No doubt only small portions of total supplies of and demands for waiting
confront each other directly on the market for loans. The marginal yields
(MERs) on bonds, equities, land and all sorts of capital goods tend to become
equal, subject to qualifications already mentioned (again compare Chapter 2).
Our emphasis on the mutual determination of marginal yields illustrates the
superficiality of theories that consider only the loan market, money and liquidity
preference. It also illuminates the pervasiveness and fundamentally real
character of the interest rate.

WAITING FURTHER EXAMINED

This section presents a few examples of the demand for and supply of waiting.
An occupier of a house might demand waiting in two ways. He might rent the
house, paying for its services month by month and letting the landlord wait to
receive the value of those services over time. Alternatively, the occupier might
buy a house with borrowed money, having the lender perform the waiting. The
house occupiers own influence on the general level of interest rates should be
about the same in the two cases. But if he has become more thrifty and instead
of renting a house buys one after saving to accumulate the purchase price or at
least a large downpayment, or else pays for the house out of already accumu-
lated savings that would otherwise have been spent on current consumption,
then his thriftiness adds to the supply of waiting and does tend to reduce interest
rates. If, conversely, a house owner sells his house and spends the proceeds on
a world tour, intending to become a renter when he returns, then his behavior
tends to raise interest rates.
Someone who rents a machine, which by its very nature incorporates waiting,
is demanding waiting while its owner is supplying it. A firm that itself finances
its holdings of capital and intermediate goods while it awaits their ripening into
salable products is thereby contributing to the aggregate supply of waiting as
well as to the demand. A firm employing capital goods in its operations is playing