Farmers law extended
Normally speaking we will not save all our money, but also consume some: Ms < M. When banks do not lend out all the money that is entrusted to them, the multiplier is less then 1: Mu < 1. Then:
R * Mu < P * M/Ms (5)
In words: if there is only a little saving (if Ms is low versus M) and also little investing as percentage of the total money supply (or equally so as percentage of the total economy), the interest charged can be quite high, even if the productivity increase (or price drop) is not very high. The public at large will still be better off with little investments at low productivity, because of the low base they are starting at. This was for instance the case in China the beginning of the 1980’s. Or in Europe right after world war II.
When there is a lot of saving and consequently a lot of investments as percentage of total money supply (or equally so as percentage of the total economy), we can expect the productivity gains to drop. Why? Well, if every one is investing, chances are they are starting to chase the same opportunities. Productivity will still increase but the gains will be lower. If the productivity declines then there is a number of ways the economy can respond:
- Mu can go down: banks will invest less of the money entrusted to them. If banks expect no further productivity gains, they prefer not to invest. It would be too risky to make bad investments, because in case of defaults the banks runs the risk of not being able to pay back the money to the people who saved. Note that this is especially the case if there is no central bank to support the banks.
- Ms can go down: if the people at large realize that productivity gains in the future will be lower, they may prefer to consume more now: remember, people have the choice to either consume or to save. Consuming more now, means saving and investing less now.
- The interest rate should go down. In that case new investments in projects with lower productivity gains can still occur. What happens to the interest rate cannot be told for sure. Maybe due to the increased savings banks can offer a lower rate to their customers and pass through a lower rate to borrowers. Possibly, banks will demand higher interest rates, due to the increased risk profile of investments. If banks decide not to lower interest rates, new additional investment just will not take place.
This puts a break on how much is invested in the society at large. Because the expected returns of new investments are lower, it does not pay off to invest more. This is not bad for the economy: consumers may decide to consume more. It just means the production structure will not deepen further by investing in the production process or in new products. Banks will be able to pay back deposits to the consumers needed to expand their consumption, which is perfectly possible, because the money is still there.
However, we do not live under the gold standard, so Mu is more than 1, Mu > 1.
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