To Graphically See How the Interest Rate Regulates the Intertemporal Allocation of Resources, We Combine the NPV and Loanable Funds Diagrams

The crossover rate is the interest rate at which the two NPV [net present value] profiles cross. The wooden bridge has a higher NPV ranking when the interest rate is above the crossover rate, and the steel bridge has a higher NPV ranking when the interest rate is below the crossover rate. The two profiles cross because the steel bridge has a flatter profile than the wooden bridge. The steel bridge’s flatter NPV profile reflects that the net present value of the steel bridge is more interest rate sensitive than the net present value of the wooden bridge. When the interest rate changes by a given amount, the percentage change in the net present value of the steel bridge is greater than the percentage change in the net present value of the wooden bridge. In general, long-term projects are more interest rate sensitive than short-term projects. 

The interest rate regulates the intertemporal allocation of resources in the present value approach to economic calculation. To demonstrate, Figure 3 combines the NPV diagram and the loanable funds diagram. In Figure 3, the interest rate determined in the loanable funds market is greater than the crossover rate, so the wooden bridge has a higher NPV ranking. In this case the investor will allocate resources to the wooden bridge. 

Now suppose there is a change in consumer preferences so that consumers save more and consume less. The increase in the supply of savings causes the supply of loanable funds curve to shift to the right, from S to S′. The increase in saving reduces the interest rate and increases the amount of investment. 

Figure 4 shows that the increase in saving by consumers changes the investor’s NPV rankings. At the lower interest rate the NPV rankings tell the investor to allocate resources to the steel bridge. . . . 

Figure 4 shows how the interest rate coordinates the actions of consumers, savers, and investors by adjusting investors’ NPV rankings to reflect changes in the saving behavior of consumers.

—Edward W. Fuller, “The Marginal Efficiency of Capital,” Quarterly Journal of Austrian Economics 16, no. 4 (Winter 2013): 386-388.