Overview of the Relationship
- Capital refers to the resources used in the production of goods and services.
- Interest is the cost of using capital or the return on investing capital.
- The relationship between the two is foundational to understanding how resources are allocated, how investments are made, and how economies grow over time.
Classical Theory of Capital and Interest
- Developed by economists like Adam Smith and David Ricardo.
- Interest is seen as the reward for saving and postponing consumption.
- Capital supply comes from savings; demand comes from investment needs.
- The equilibrium interest rate is determined where the supply of savings equals the demand for investment.
Keynesian View
- Developed by John Maynard Keynes in the 20th century.
- Interest is not solely determined by saving and investment but by the liquidity preference of the public.
- People prefer to hold cash unless they are incentivized by interest rates to invest or lend.
- Interest rate balances the demand for money with the supply of money, not just capital supply and demand.
Austrian School Perspective
- Prominent economists: Eugen Böhm-Bawerk and Ludwig von Mises.
- Interest arises naturally from time preference—people value present goods more than future goods.
- Capital is viewed as a structure of production that takes time to yield returns.
- Interest reflects the intertemporal exchange between present and future consumption.
Modern Neoclassical Approach
- Combines elements from classical and Keynesian theories.
- Interest is the marginal productivity of capital—the additional output generated by one more unit of capital.
- Capital flows to where it earns the highest return (interest), ensuring optimal allocation of resources.
- In equilibrium, the interest rate equals the rate of return on the most productive use of capital.
Capital and Interest in Business Decisions
- Firms evaluate the cost of capital (interest) before undertaking new investments.
- Projects must yield returns higher than the interest rate to be viable (Net Present Value & Internal Rate of Return).
- Low interest rates encourage borrowing and capital accumulation; high rates discourage investment.
Implications for Economic Growth
- Capital accumulation drives productivity and output growth.
- Efficient interest rates guide savings into productive investments.
- Distorted interest rates (due to inflation, regulation, or financial crises) misallocate capital and hinder growth.
Capital and Interest as Dual Engines of Economic Development
The dynamic relationship between capital and interest is central to investment, growth, and resource allocation. Capital is the tool; interest is the price of using it. Together, they form the core of financial decision-making, influence economic cycles, and shape long-term development strategies in both microeconomic and macroeconomic contexts.