6.03. Time Preference and Individual Value Scales

0:003. Time Preference and Individual Value Scales 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. 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. This is no less true in regard to the interest rate. Here the key is the schedule of time preference valuations of the individual. Let us consider a hypothetical individual, abstracting from any particular role that he may play in the economic system. This individual has, of necessity, a diminishing marginal utility of money, so that each additional unit of of Money acquired ranks lower on his value scale.

0:59This is necessarily true. Conversely, and this also follows from the diminishing marginal utility of money, each successive unit of money given up will rank higher on his value scale. The same law of utility applies to future money, that is, to prospects of future money. To both present money and future money, There applies the general rule that more of a good will have greater utility than less of it. We may illustrate these general laws by means of the following hypothetical value scale of an individual. For John Smith, at the top of his value scale is 19 ounces in the future, 10 years from

2:16Followed by 12 ounces in the future, followed by the first unit of 10 ounces, followed by 11 ounces in the future, followed by the first added unit of 10 ounces, followed by the second added unit of 10 ounces, followed by 10 ounces in the future. We see in this value scale an example of the fact that all possible alternatives for choice are ranged in one scale, and the truths of the law of utility are exemplified. The first unit of 10 ounces refers to the rank accorded to the first unit of 10 ounces, the unit arbitrarily chosen here, to be given up.

3:02The second unit of 10 ounces of money to be given up is accorded higher rank, etc. 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. We thus have a schedule of John Smith's value scale with respect to time, that is, his scale of time preferences. 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. To see what he will do, we are privileged to be able to consult his time preference scale.

3:51We 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. 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. He is a supplier of present goods on the time market to the extent of 20 ounces. This is a highly simplified portrayal of the value scale. For purposes of exposition, we have omitted the fact that the second unit of 13 added future ounces will be worth less than the first, the third unit of 13 less than the second, etc.

4:46Thus, in actuality, the demand schedule of future goods will be lower than portrayed. However, the essentials of the analysis are unaffected, since we can assume a demand schedule of any size that we wish. The only significant conclusion is that an individual demands more future goods as the market rate of interest rises, and this conclusion holds for the actual as well as for our simplified Version. If the market rate of interest is 2 percent, so that 12 future ounces would be the price of 10 present ounces, then John Smith would be a supplier of 10 ounces of present money. He is never a supplier of future money because in his particular case there are no quantities of Future Money above 10 ounces that are ranked below first added unit of 10 ounces.

5:48Suppose for example that James Robinson has the following time value scale. At the top of the scale, 19 ounces in the future 10 years from now, followed by a second The Theory of Money and Credit First Added Unit of 10 Ounces and 10 Ounces in the Future If the market rate of interest is 3%, then Robinson's valuations are such that no savings will be supplied to the time market.

6:46On the contrary, 13 ounces in the future is lower than first added unit of 10 ounces, Which means that Robinson would be willing to exchange 13 ounces of future money for 10 ounces of present money. Thereby he becomes, in contrast to Smith, a supplier of future money. If the rate of interest were 1%, then he would supply 22 ounces of future money in exchange for 20 ounces of present money, thus increasing his demand for present money at the lower 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.

7:36The reason is that every man's time preference is positive, that is, one ounce of present money will always be preferred to one ounce or less of future money, therefore there will never be any question of a zero or negative pure interest rate. Many economists have made the great mistake of believing that the interest rate determines is the time preference schedule and rate of savings, rather than vice versa. This is completely invalid. The interest rates discussed here are simply hypothetical schedules, and they indicate and reveal the time preference schedules of each individual.

8:21In the aggregate, as we shall see presently, the interaction of the time preferences, and Hence, the supply-demand schedules of individuals on the time market determine the pure rate of interest on the market. They do so in the same way that individual valuations determine aggregate supply and demand schedules for goods, which in turn determine market prices. And once again, it is utilities and utilities alone, here in the form of time preferences, determine the market result. The explanation does not lie in some sort of mutually determining process of preferences and market consequences. Continuing with our analysis, let us consider the schedules of John Smith and James Robinson from their time value scales in relation to to their position on the time market.

9:22For John Smith, at an interest rate of 9%, he will supply 40 ounces of present money. At an interest rate of 8, 7 or 6%, he will supply 30 ounces of present money. At an interest rate of 5% or 4% or 3%, he will supply 20 ounces of present money. At an interest rate of 2%, he will supply 10 ounces of present money. And at an interest rate of 1%, he will supply no present money. At no interest rate will John Smith supply any future money. James Robinson at an interest rate of 9% will supply 20 ounces of present money.

10:12At an interest rate of 8 or 7 percent, he will supply 10 ounces of present money. At no interest rate lower than 7 percent, will James Robinson supply any present money. He will supply no future money at any interest rate above 3 percent. At an interest rate of 3 percent, he will supply 10 ounces of future money. At an interest rate of 2%, he will supply 10 ounces of future money, and at an interest rate of 1%, he will supply 20 ounces of future money. The Robinson time schedule is of particular interest. Referring to his time value scale, we find that at an interest rate of 9%, 19 ounces His of future money is above the second unit of 10 ounces of present money, and therefore also above the first unit.

11:15At this interest rate, his supply of present money on the time market, that is, his savings, equals 20 ounces. Because his valuation of the first unit of 10 ounces, an arbitrary size of unit that We have picked for this discussion is between 16 and 17 ounces of future money. When the market interest rate is 6%, his return of 16 ounces is less valuable to him than his first unit. Therefore, he will not be a saver and supplier of present money at this rate. On the other hand, he will will not be a supplier of future goods, that is, a demander of present goods on the time market either.

12:02In order to be a supplier of future goods, his valuation of the future money that he would have to give up, at the ruling rate of interest, has to be lower than the present money that he would get. In other words, what he gives up in prospective future money will have to be worth less to to him than the utility of the first additional unit of 10 ounces on his scale. While the market rate is in the 4% to 6% range, this will not be true, for the 14 to 16 ounces of future money that he would have to supply would be worth more to him than the additional 10 ounces of present money that he would gain from the exchange.

12:49In Robinson's case, the critical point takes place when the hypothetical interest rate drops to 3%, for 13 future ounces are worth less than an additional 10 ounces of present money, and he will supply the future ounces on the market. If the interest rate were 1%, he would supply 20 ounces of future goods. It should be evident that an individual at any one time will either be a net saver, that is, a net demander of future goods, a net supplier of future goods, or not be on the time market at all. The three categories are mutually exclusive.

13:36We cannot compare utilities or values between persons, but we certainly may say that Robinson's Robinson's time preference schedule is higher than Smith's. In other words, it cannot make sense to compare the rankings or utilities that the two men accord to any particular unit of a good, but we can, if we know them, compare their schedules based purely on their demonstrated time preferences. Robinson's time preference schedule is higher than Smith's. That is, at each hypothetical rate of interest, Robinson's values are such that he will part with less of his present goods in exchange for future goods. In the same way, though we cannot compare utilities, we can compare, if we know them, individual demand schedules for goods.

14:36Let us explore the typical individual time preference schedule, or time supply and demand schedule, more closely. In the first place, there is no necessity for the unit chosen to be 10 ounces. Since money is perhaps the most divisible of goods, it is possible to break down the units into far smaller sizes. Furthermore, because of the arbitrage of the market, the rate of interest return on investments of present and future goods will be equal for all the various sizes of units. One inevitable characteristic of an individual's time preference schedule is that eventually, after a certain amount of present money has been supplied on the market, no conceivable The Federal interest rate could persuade him to purchase more future goods.

15:31The reason is that as present money dwindles and future money increases in a man's possession, the marginal utility of the former increases on the man's value scale, and the marginal utility of the latter decreases. In particular, every man must consume in the present, and this drastically limits his savings regardless of the interest rate. As a result, after a certain point, a man's time preference for the present becomes infinite. At the other end of the scale, the fact of time preference will imply that at some minimum rate of interest, the man will not save at all. A man could not prefer 10 ounces or even less of future money to 10 ounces of present money.

16:23It is not valid to object that some might prefer to use the money in the future rather than in the present. That is not the issue here, which is one of availability for use. If a man wants to save money for some future use, he may hoard it rather than spend it on a future good, and thus have it always available. We have abstracted from hoarding, which will be dealt with in the chapter on money. It would have no place, anyway, in the evenly rotating world of certainty. What happens depends entirely on the time preferences of the individual. In some cases, as in that of John Smith, the person's marginal utility of money falls In other words, Smith's time preference ratio is too low in this area for him to become a demander of present goods and a supplier of future goods.

17:35On the other hand, Robinson's higher schedule of time preferences is such that at low rates

18:12Net Demander. At each hypothetical rate of interest there is a possible net saving, net demanding or abstaining from the market for each individual. For some changes in the rate of interest there will be no change but there will never be a situation where the supply will be greater or demand less with lower rates Rates of Interest The time market schedules of all individuals are aggregated on the market to form market supply and market demand schedules for present goods in terms of future goods. The supply schedule will increase with an increase in the rate of interest, and the demand schedule will fall with the higher rates of interest.

19:04The equilibrium rate of interest, the rate of interest as it would tend to be in the evenly rotating economy, this pure rate of interest is determined solely by the time preferences of the individuals in the society and by no other factor. Perhaps more fallacies have been committed in discussions concerning the interest rate than in the treatment of any other aspect of economics. It took a long while for the crucial importance of time preference and the determination of the pure rate of interest to be realized in economics. It took even longer for economists to realize that time preference is the only determining factor.

19:52Reluctance to accept a monistic causal interpretation has plagued economics to this day. Thank you for watching.