Hayek Discusses a SHRINKAGE of the PRICE MARGINS When an Increase in the Rate of Saving Lowers the Equilibrium Rate of Interest

To assist in the explanation of these structural changes which occur periodically under a system of capitalistic production, Hayek invokes an ingenious relationship between changes in the rate of interest, and the changes which take place in the relative values of different goods, used at different stages in the process of production. He states that there will be a difference between the value of a unit of output from one stage of production and the value of the unit of output at the succeeding stage, — and this difference he calls a “price margin.” Thus for any stage, the selling price of its output exceeds the value of the input of raw materials, labour, etc., by an amount which constitutes the source of interest whilst,  “in a state of equilibrium, these margins are entirely absorbed by interest.” This would seem to follow from Hayek’s particular interpretation of economic equilibrium as depending on a certain relationship between the prices of producers’ goods and the prices of consumers’ goods, a relationship which will be solely determined by the preference of consumers as between saving and spending,

Every given structure of production, i.e., every given allocation of goods as between different branches of production requires a certain definite relationship between the prices of the finished products and those of the means of production. In a state of equilibrium, the difference necessarily existing between these two sets of prices must correspond to the rate of interest. . . . 

Under barter conditions, the rate of interest, and thus these price relationships, will be unlikely to diverge from their equilibrium values since “. . . the reciprocal gains and sacrifices of saving borrowing and lending are concretely juxtaposed and deviations from an equilibrium position are more obviously and more directly carry their penalties with them.” Likewise in a money economy, in which the supply of credit is kept equal to the supply of savings, there will tend to be a close correspondence between changes in price margins and in the rate of interest.

An increase in the rate of saving which lowers the equilibrium rate of interest will, Hayek suggests, involve a corresponding shrinkage of the price margins. This is because greater saving leads both to a reduction in the demand for consumers’ goods which reduces their prices, and the prices of the goods at the stages immediately preceding; and also to a rise in the demand for, and in the price of, products at the earlier stages, and the latter change is transmitted towards the later stages, (but with diminishing intensity), until the price margins are again all equal, and equivalent to a lower rate of interest.

—G. F. D. Palmer, “The Trade Cycle Theories of R. G. Hawtrey and F. A. von Hayek, with Particular Reference to the Rôle Attributed by Each to the Rate of Interest” (master’s thesis, University of Cape Town, July 1951), 27-29.