WEBVTT NOTE 6.03. Time Preference and Individual Value Scales 1 00:00:00.000 --> 00:00:06.000 3. Time Preference and Individual Value Scales 2 00:00:06.000 --> 00:00:17.000 Before considering the component parts of the time market further, let us go to the very root of the matter, the value scale of the individual. 3 00:00:17.000 --> 00:00:28.000 As we have seen in the problem of pricing and demand, the individual's value scale provides the key to the determination of all events on the market. 4 00:00:28.000 --> 00:00:34.240 This is no less true in regard to the interest rate. Here the key is the schedule of time 5 00:00:34.240 --> 00:00:41.620 preference valuations of the individual. Let us consider a hypothetical individual, abstracting 6 00:00:41.620 --> 00:00:48.200 from any particular role that he may play in the economic system. This individual has, 7 00:00:48.200 --> 00:00:54.680 of necessity, a diminishing marginal utility of money, so that each additional unit of 8 00:00:54.680 --> 00:00:59.320 of Money acquired ranks lower on his value scale. 9 00:00:59.320 --> 00:01:01.760 This is necessarily true. 10 00:01:01.760 --> 00:01:04.320 Conversely, and this also follows 11 00:01:04.320 --> 00:01:07.540 from the diminishing marginal utility of money, 12 00:01:07.540 --> 00:01:10.720 each successive unit of money given up 13 00:01:10.720 --> 00:01:14.200 will rank higher on his value scale. 14 00:01:14.200 --> 00:01:17.880 The same law of utility applies to future money, 15 00:01:17.880 --> 00:01:21.360 that is, to prospects of future money. 16 00:01:21.360 --> 00:01:24.000 To both present money and future money, 17 00:01:24.000 --> 00:01:30.560 There applies the general rule that more of a good will have greater utility than less 18 00:01:30.560 --> 00:01:31.560 of it. 19 00:01:31.560 --> 00:01:37.280 We may illustrate these general laws by means of the following hypothetical value scale 20 00:01:37.280 --> 00:01:39.240 of an individual. 21 00:01:39.240 --> 00:01:46.400 For John Smith, at the top of his value scale is 19 ounces in the future, 10 years from 22 00:02:16.400 --> 00:02:22.780 Followed by 12 ounces in the future, followed by the first unit of 10 ounces, 23 00:02:22.780 --> 00:02:30.360 followed by 11 ounces in the future, followed by the first added unit of 10 ounces, 24 00:02:30.360 --> 00:02:37.240 followed by the second added unit of 10 ounces, followed by 10 ounces in the future. 25 00:02:37.240 --> 00:02:44.320 We see in this value scale an example of the fact that all possible alternatives for choice 26 00:02:44.320 --> 00:02:51.040 are ranged in one scale, and the truths of the law of utility are exemplified. 27 00:02:51.040 --> 00:02:58.440 The first unit of 10 ounces refers to the rank accorded to the first unit of 10 ounces, 28 00:02:58.440 --> 00:03:02.640 the unit arbitrarily chosen here, to be given up. 29 00:03:02.640 --> 00:03:09.440 The second unit of 10 ounces of money to be given up is accorded higher rank, etc. 30 00:03:09.440 --> 00:03:19.940 The first added unit of 10 ounces refers to the rank accorded to the next unit of 10 ounces which the man is considering acquiring. 31 00:03:19.940 --> 00:03:29.440 We thus have a schedule of John Smith's value scale with respect to time, that is, his scale of time preferences. 32 00:03:29.440 --> 00:03:45.440 Suppose that the market rate of interest then is 3%, that is, he can obtain 13 ounces of future money, considered here as 10 years from now, by selling 10 ounces of present money. 33 00:03:45.440 --> 00:03:51.440 To see what he will do, we are privileged to be able to consult his time preference scale. 34 00:03:51.440 --> 00:04:07.940 We find that 13 ounces of future money is preferred to his first unit of 10 ounces and also to the second unit of 10 ounces, but that the third unit of 10 ounces stands higher in his valuation. 35 00:04:07.940 --> 00:04:19.940 Therefore, with a market rate of 3% per year, the individual will save 20 ounces of gold and sell them for future money on the time market. 36 00:04:19.940 --> 00:04:27.700 He is a supplier of present goods on the time market to the extent of 20 ounces. 37 00:04:27.700 --> 00:04:31.940 This is a highly simplified portrayal of the value scale. 38 00:04:31.940 --> 00:04:38.220 For purposes of exposition, we have omitted the fact that the second unit of 13 added 39 00:04:38.220 --> 00:04:44.780 future ounces will be worth less than the first, the third unit of 13 less than the 40 00:04:44.780 --> 00:04:46.340 second, etc. 41 00:04:46.340 --> 00:04:53.300 Thus, in actuality, the demand schedule of future goods will be lower than portrayed. 42 00:04:53.300 --> 00:04:59.700 However, the essentials of the analysis are unaffected, since we can assume a demand schedule 43 00:04:59.700 --> 00:05:02.140 of any size that we wish. 44 00:05:02.140 --> 00:05:08.500 The only significant conclusion is that an individual demands more future goods as the 45 00:05:08.500 --> 00:05:15.900 market rate of interest rises, and this conclusion holds for the actual as well as for our simplified 46 00:05:15.900 --> 00:05:17.540 Version. 47 00:05:17.540 --> 00:05:23.300 If the market rate of interest is 2 percent, so that 12 future ounces would be the price 48 00:05:23.300 --> 00:05:31.300 of 10 present ounces, then John Smith would be a supplier of 10 ounces of present money. 49 00:05:31.300 --> 00:05:38.820 He is never a supplier of future money because in his particular case there are no quantities 50 00:05:38.820 --> 00:05:48.180 of Future Money above 10 ounces that are ranked below first added unit of 10 ounces. 51 00:05:48.180 --> 00:05:53.820 Suppose for example that James Robinson has the following time value scale. 52 00:05:53.820 --> 00:06:00.620 At the top of the scale, 19 ounces in the future 10 years from now, followed by a second 53 00:06:00.620 --> 00:06:30.620 The Theory of Money and Credit 54 00:06:30.620 --> 00:06:36.300 First Added Unit of 10 Ounces and 10 Ounces in the Future 55 00:06:36.300 --> 00:06:43.300 If the market rate of interest is 3%, then Robinson's valuations are such that no savings 56 00:06:43.300 --> 00:06:46.260 will be supplied to the time market. 57 00:06:46.260 --> 00:06:54.580 On the contrary, 13 ounces in the future is lower than first added unit of 10 ounces, 58 00:06:54.580 --> 00:07:00.980 Which means that Robinson would be willing to exchange 13 ounces of future money for 59 00:07:00.980 --> 00:07:03.700 10 ounces of present money. 60 00:07:03.700 --> 00:07:09.940 Thereby he becomes, in contrast to Smith, a supplier of future money. 61 00:07:09.940 --> 00:07:17.420 If the rate of interest were 1%, then he would supply 22 ounces of future money in exchange 62 00:07:17.420 --> 00:07:24.500 for 20 ounces of present money, thus increasing his demand for present money at the lower 63 00:07:24.500 --> 00:07:36.500 The Theory of Money and Credit It will be noticed that there is no listing for less than 10 ounces of future goods to be compared with 10 ounces of present goods. 64 00:07:36.500 --> 00:07:43.260 The reason is that every man's time preference is positive, that is, one ounce of present 65 00:07:43.260 --> 00:07:50.100 money will always be preferred to one ounce or less of future money, therefore there will 66 00:07:50.100 --> 00:07:56.340 never be any question of a zero or negative pure interest rate. 67 00:07:56.340 --> 00:08:01.620 Many economists have made the great mistake of believing that the interest rate determines 68 00:08:01.620 --> 00:08:07.800 is the time preference schedule and rate of savings, rather than vice versa. 69 00:08:07.800 --> 00:08:10.120 This is completely invalid. 70 00:08:10.120 --> 00:08:16.520 The interest rates discussed here are simply hypothetical schedules, and they indicate and 71 00:08:16.520 --> 00:08:21.500 reveal the time preference schedules of each individual. 72 00:08:21.500 --> 00:08:27.820 In the aggregate, as we shall see presently, the interaction of the time preferences, and 73 00:08:27.820 --> 00:08:34.900 Hence, the supply-demand schedules of individuals on the time market determine the pure rate 74 00:08:34.900 --> 00:08:37.220 of interest on the market. 75 00:08:37.220 --> 00:08:43.340 They do so in the same way that individual valuations determine aggregate supply and 76 00:08:43.340 --> 00:08:49.260 demand schedules for goods, which in turn determine market prices. 77 00:08:49.260 --> 00:08:56.860 And once again, it is utilities and utilities alone, here in the form of time preferences, 78 00:08:56.860 --> 00:09:03.980 determine the market result. The explanation does not lie in some sort of mutually determining 79 00:09:03.980 --> 00:09:12.100 process of preferences and market consequences. Continuing with our analysis, let us consider 80 00:09:12.100 --> 00:09:19.180 the schedules of John Smith and James Robinson from their time value scales in relation to 81 00:09:19.180 --> 00:09:22.460 to their position on the time market. 82 00:09:22.460 --> 00:09:31.180 For John Smith, at an interest rate of 9%, he will supply 40 ounces of present money. 83 00:09:31.180 --> 00:09:39.060 At an interest rate of 8, 7 or 6%, he will supply 30 ounces of present money. 84 00:09:39.060 --> 00:09:47.800 At an interest rate of 5% or 4% or 3%, he will supply 20 ounces of present money. 85 00:09:47.800 --> 00:09:53.760 At an interest rate of 2%, he will supply 10 ounces of present money. 86 00:09:53.760 --> 00:09:59.360 And at an interest rate of 1%, he will supply no present money. 87 00:09:59.360 --> 00:10:05.400 At no interest rate will John Smith supply any future money. 88 00:10:05.400 --> 00:10:12.600 James Robinson at an interest rate of 9% will supply 20 ounces of present money. 89 00:10:12.600 --> 00:10:19.520 At an interest rate of 8 or 7 percent, he will supply 10 ounces of present money. 90 00:10:19.520 --> 00:10:27.480 At no interest rate lower than 7 percent, will James Robinson supply any present money. 91 00:10:27.480 --> 00:10:33.980 He will supply no future money at any interest rate above 3 percent. 92 00:10:33.980 --> 00:10:40.220 At an interest rate of 3 percent, he will supply 10 ounces of future money. 93 00:10:40.220 --> 00:10:46.500 At an interest rate of 2%, he will supply 10 ounces of future money, and at an interest 94 00:10:46.500 --> 00:10:52.940 rate of 1%, he will supply 20 ounces of future money. 95 00:10:52.940 --> 00:10:57.460 The Robinson time schedule is of particular interest. 96 00:10:57.460 --> 00:11:05.300 Referring to his time value scale, we find that at an interest rate of 9%, 19 ounces 97 00:11:05.300 --> 00:11:12.160 His of future money is above the second unit of 10 ounces of present money, and therefore 98 00:11:12.160 --> 00:11:15.060 also above the first unit. 99 00:11:15.060 --> 00:11:21.620 At this interest rate, his supply of present money on the time market, that is, his savings, 100 00:11:21.620 --> 00:11:24.100 equals 20 ounces. 101 00:11:24.100 --> 00:11:30.260 Because his valuation of the first unit of 10 ounces, an arbitrary size of unit that 102 00:11:30.260 --> 00:11:37.940 We have picked for this discussion is between 16 and 17 ounces of future money. When the market 103 00:11:37.940 --> 00:11:47.300 interest rate is 6%, his return of 16 ounces is less valuable to him than his first unit. Therefore, 104 00:11:47.300 --> 00:11:54.180 he will not be a saver and supplier of present money at this rate. On the other hand, he will 105 00:11:54.180 --> 00:12:00.640 will not be a supplier of future goods, that is, a demander of present goods on the time 106 00:12:00.640 --> 00:12:02.340 market either. 107 00:12:02.340 --> 00:12:08.040 In order to be a supplier of future goods, his valuation of the future money that he 108 00:12:08.040 --> 00:12:13.860 would have to give up, at the ruling rate of interest, has to be lower than the present 109 00:12:13.860 --> 00:12:16.000 money that he would get. 110 00:12:16.000 --> 00:12:22.440 In other words, what he gives up in prospective future money will have to be worth less to 111 00:12:22.440 --> 00:12:29.640 to him than the utility of the first additional unit of 10 ounces on his scale. 112 00:12:29.640 --> 00:12:38.240 While the market rate is in the 4% to 6% range, this will not be true, for the 14 to 16 ounces 113 00:12:38.240 --> 00:12:44.360 of future money that he would have to supply would be worth more to him than the additional 114 00:12:44.360 --> 00:12:49.640 10 ounces of present money that he would gain from the exchange. 115 00:12:49.640 --> 00:12:55.900 In Robinson's case, the critical point takes place when the hypothetical interest rate drops 116 00:12:55.900 --> 00:13:04.860 to 3%, for 13 future ounces are worth less than an additional 10 ounces of present money, 117 00:13:04.860 --> 00:13:08.880 and he will supply the future ounces on the market. 118 00:13:08.880 --> 00:13:15.740 If the interest rate were 1%, he would supply 20 ounces of future goods. 119 00:13:15.740 --> 00:13:22.440 It should be evident that an individual at any one time will either be a net saver, that 120 00:13:22.440 --> 00:13:30.400 is, a net demander of future goods, a net supplier of future goods, or not be on the 121 00:13:30.400 --> 00:13:32.440 time market at all. 122 00:13:32.440 --> 00:13:36.720 The three categories are mutually exclusive. 123 00:13:36.720 --> 00:13:44.220 We cannot compare utilities or values between persons, but we certainly may say that Robinson's 124 00:13:44.220 --> 00:13:48.600 Robinson's time preference schedule is higher than Smith's. 125 00:13:48.600 --> 00:13:55.120 In other words, it cannot make sense to compare the rankings or utilities that the two men 126 00:13:55.120 --> 00:14:03.380 accord to any particular unit of a good, but we can, if we know them, compare their schedules 127 00:14:03.380 --> 00:14:08.440 based purely on their demonstrated time preferences. 128 00:14:08.440 --> 00:14:14.760 Robinson's time preference schedule is higher than Smith's. That is, at each hypothetical 129 00:14:14.760 --> 00:14:21.120 rate of interest, Robinson's values are such that he will part with less of his present 130 00:14:21.120 --> 00:14:28.880 goods in exchange for future goods. In the same way, though we cannot compare utilities, 131 00:14:28.880 --> 00:14:36.400 we can compare, if we know them, individual demand schedules for goods. 132 00:14:36.400 --> 00:14:43.500 Let us explore the typical individual time preference schedule, or time supply and demand 133 00:14:43.500 --> 00:14:46.160 schedule, more closely. 134 00:14:46.160 --> 00:14:52.340 In the first place, there is no necessity for the unit chosen to be 10 ounces. 135 00:14:52.340 --> 00:14:58.040 Since money is perhaps the most divisible of goods, it is possible to break down the 136 00:14:58.040 --> 00:15:00.920 units into far smaller sizes. 137 00:15:00.920 --> 00:15:07.160 Furthermore, because of the arbitrage of the market, the rate of interest return on investments 138 00:15:07.160 --> 00:15:14.720 of present and future goods will be equal for all the various sizes of units. 139 00:15:14.720 --> 00:15:21.400 One inevitable characteristic of an individual's time preference schedule is that eventually, 140 00:15:21.400 --> 00:15:26.920 after a certain amount of present money has been supplied on the market, no conceivable 141 00:15:26.920 --> 00:15:31.760 The Federal interest rate could persuade him to purchase more future goods. 142 00:15:31.760 --> 00:15:38.600 The reason is that as present money dwindles and future money increases in a man's possession, 143 00:15:38.600 --> 00:15:45.080 the marginal utility of the former increases on the man's value scale, and the marginal 144 00:15:45.080 --> 00:15:48.520 utility of the latter decreases. 145 00:15:48.520 --> 00:15:56.040 In particular, every man must consume in the present, and this drastically limits his savings 146 00:15:56.040 --> 00:15:58.320 regardless of the interest rate. 147 00:15:58.320 --> 00:16:05.300 As a result, after a certain point, a man's time preference for the present becomes infinite. 148 00:16:05.300 --> 00:16:10.780 At the other end of the scale, the fact of time preference will imply that at some minimum 149 00:16:10.780 --> 00:16:14.600 rate of interest, the man will not save at all. 150 00:16:14.600 --> 00:16:23.320 A man could not prefer 10 ounces or even less of future money to 10 ounces of present money. 151 00:16:23.320 --> 00:16:29.940 It is not valid to object that some might prefer to use the money in the future rather 152 00:16:29.940 --> 00:16:31.740 than in the present. 153 00:16:31.740 --> 00:16:37.380 That is not the issue here, which is one of availability for use. 154 00:16:37.380 --> 00:16:43.720 If a man wants to save money for some future use, he may hoard it rather than spend it 155 00:16:43.720 --> 00:16:48.060 on a future good, and thus have it always available. 156 00:16:48.060 --> 00:16:53.820 We have abstracted from hoarding, which will be dealt with in the chapter on money. 157 00:16:53.820 --> 00:17:00.400 It would have no place, anyway, in the evenly rotating world of certainty. 158 00:17:00.400 --> 00:17:06.600 What happens depends entirely on the time preferences of the individual. 159 00:17:06.600 --> 00:17:12.820 In some cases, as in that of John Smith, the person's marginal utility of money falls 160 00:17:12.820 --> 00:17:30.380 In other words, Smith's time preference ratio is too low in this area for him to become 161 00:17:30.380 --> 00:17:35.900 a demander of present goods and a supplier of future goods. 162 00:17:35.900 --> 00:17:42.220 On the other hand, Robinson's higher schedule of time preferences is such that at low rates 163 00:18:12.220 --> 00:18:18.360 Net Demander. At each hypothetical rate of interest there is a possible net 164 00:18:18.360 --> 00:18:25.460 saving, net demanding or abstaining from the market for each individual. For some 165 00:18:25.460 --> 00:18:30.300 changes in the rate of interest there will be no change but there will never 166 00:18:30.300 --> 00:18:37.440 be a situation where the supply will be greater or demand less with lower rates 167 00:18:37.440 --> 00:18:39.320 Rates of Interest 168 00:18:39.320 --> 00:18:45.880 The time market schedules of all individuals are aggregated on the market to form market 169 00:18:45.880 --> 00:18:53.160 supply and market demand schedules for present goods in terms of future goods. 170 00:18:53.160 --> 00:18:58.900 The supply schedule will increase with an increase in the rate of interest, and the 171 00:18:58.900 --> 00:19:04.000 demand schedule will fall with the higher rates of interest. 172 00:19:04.000 --> 00:19:09.360 The equilibrium rate of interest, the rate of interest as it would tend to be in the 173 00:19:09.360 --> 00:19:17.120 evenly rotating economy, this pure rate of interest is determined solely by the time 174 00:19:17.120 --> 00:19:24.880 preferences of the individuals in the society and by no other factor. 175 00:19:24.880 --> 00:19:30.320 Perhaps more fallacies have been committed in discussions concerning the interest rate 176 00:19:30.320 --> 00:19:34.240 than in the treatment of any other aspect of economics. 177 00:19:34.240 --> 00:19:39.920 It took a long while for the crucial importance of time preference and the determination of 178 00:19:39.920 --> 00:19:44.080 the pure rate of interest to be realized in economics. 179 00:19:44.080 --> 00:19:50.600 It took even longer for economists to realize that time preference is the only determining 180 00:19:50.600 --> 00:19:52.080 factor. 181 00:19:52.080 --> 00:19:59.040 Reluctance to accept a monistic causal interpretation has plagued economics to this day. 182 00:20:00.320 --> 00:20:02.320 Thank you for watching.