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.

Mises and Keynes Adopted Different Approaches to Economic Calculation: Mises Used NPV and Keynes Used MEC

The purpose of this paper is to show how Keynesian economics represents a justification for fractional reserve banking and why this justification is fundamentally flawed. In contrast to other examinations of Keynes’s theory, this paper will highlight the marginal efficiency of capital. Like Ludwig von Mises, Keynes was a financial economist who gave economic calculation a central role in his theory. But Mises and Keynes adopted different approaches to economic calculation: Mises used the net present value and Keynes used the marginal efficiency of capital. Importantly, Keynes argued that the marginal efficiency of capital and the net present value yield identical results. Keynes was wrong: the marginal efficiency of capital contradicts the net present value, and, therefore, it is a logically defective approach to economic calculation. Consequently, Keynesian economics is not a viable justification for fractional reserve banking.

—Edward W. Fuller, “Keynes and Fractional Reserve Banking: The NPV vs. MEC,” Procesos de Mercado: Revista Europea de Economía Política 15, no. 1 (Spring 2018): 41-42.

The Theory of Effective Demand Represents Keynes’s Attack on the Loan-Market Theory

 The pre-Keynesian analysis of fractional reserve banking can be illustrated with the loan market theory, the theory of multiple deposit creation, and the net present value. Together, these three theories support 100 percent reserve banking. But Keynes wrote to Irving Fisher, “on the matter of 100 per cent money I have, however, as you know, some considerable reservations.” So how can Keynes reject 100 percent reserves? He accepted the theory of multiple deposit creation, and he accepted the theory of DCF [discounted cash flow] analysis. Thus Keynes’s most obvious departure from the pre-Keynesians was his attack on the loan-market theory.

The Keynesian theory has three components: (1) the theory of effective demand, (2) the liquidity preference theory, and (3) the marginal efficiency of capital. The theory of effective demand represents Keynes’s attack on the loan-market theory. As noted, in the loan-market theory, the interest rate is the price that adjusts to balance saving and investment. However, Keynes explicitly rejected the theory. Instead, in his theory of effective demand, the level of income is the factor that adjusts to equalize saving and investment. If investment is greater (less) than saving, then income will rise (fall) until saving equals investment. In the Keynesian theory, income replaces the interest rate as the equilibrator of saving and investment.

—Edward W. Fuller, “Keynes and Fractional Reserve Banking: The NPV vs. MEC,” Procesos de Mercado: Revista Europea de Economía Política 15, no. 1 (Spring 2018): 54.

Keynes’s Doctrines Take Us Back to the Pre-Scientific Stage of Economics When the Whole Working of the Price Mechanism Was Not Yet Understood

I cannot help regarding the increasing concentration on short-run effects—which in this context amounts to the same thing as a concentration on purely monetary factors—not only as a serious and dangerous intellectual error, but as a betrayal of the main duty of the economist and a grave menace to our civilisation. To the understanding of the forces which determine the day-to-day changes of business, the economist has probably little to contribute that the man of affairs does not know better. It used, however, to be regarded as the duty and the privilege of the economist to study and to stress the long effects which are apt to be hidden to the untrained eye, and to leave the concern about the more immediate effects to the practical man, who in any event would see only the latter and nothing else. The aim and effect of two hundred years of continuous development of economic thought have essentially been to lead us away from, and ‘behind’, the more superficial monetary mechanism and to bring out the real forces which guide long-run development. I do not wish to deny that the preoccupation with the ‘real’ as distinguished from the monetary aspects of the problems may sometimes have gone too far. But this can be no excuse for the present tendencies which have already gone far towards taking us back to the pre-scientific stage of economics, when the whole working of the price mechanism was not yet understood, and only the problems of the impact of a varying money stream on a supply of goods and services with given prices aroused interest. It is not surprising that Mr. Keynes finds his views anticipated by the mercantilist writers and gifted amateurs: concern with the surface phenomena has always marked the first stage of the scientific approach to our subject. But it is alarming to see that after we have once gone through the process of developing a systematic account of those forces which in the long run determine prices and production, we are now called upon to scrap it, in order to replace it by the short-sighted philosophy of the business man raised to the dignity of a science.

—F. A. Hayek, The Collected Works of F. A. Hayek, vol. 12, The Pure Theory of Capital, ed. Lawrence H. White (Indianapolis: Liberty Fund, 2007), 368.

The Unfortunate Distinction between Macroeconomics and Growth Theory Derives from the Inadequate Attention to the Inter-Temporal Capital Structure

Capital-based macroeconomics rejects the Keynes-inspired distinction between macroeconomics and the economics of growth. This unfortunate distinction, in fact, derives from the inadequate attention to the inter-temporal capital structure. Conventional macroeconomics deals with economy-wide disequilibria while abstracting from issues involving a changing stock of capital; modern growth theory deals with a growing capital stock while abstracting from issues involving economy-wide disequilibria. With this criterion for defining the subdisciplines within economics, the thorny issues of disequilibrium and the thorny issues of capital theory are addressed one at a time. Our contention is that economic reality mixes the two issues in ways that render the one-at-a-time treatments profoundly inadequate. Economy-wide disequilibria in the context of a changing capital structure escape the attention of both conventional macroeconomists and modern growth theorists. But the issues involving the market’s ability to allocate resources over time have a natural home in capital-based macroeconomics. Here, the short-run issues of cyclical variation and the long-run issues of secular expansion enjoy a blend that is simply ruled out by construction in mainstream theorizing. 

—Roger W. Garrison, Time and Money: The Macroeconomics of Capital Structure, Foundations of the Market Economy (London: Routledge, 2002), 34.