No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Twelve: Money Mischief 288 find it cheaper to borrow to fund longer-term capital projects (higher order goods in the structure of production). Further, as we’ll see in chapter 16, longer-term projects benefit more from lower interest rates than shorter-term projects. This means that as the interest rate falls, more and more loans will be made with a greater and greater proportion in longer-term projects. The supply of loanable funds operates in a similar manner; as interest rates rise individuals will have an incentive to abstain from current consumption and save more of their income. Therefore, our supply curve for loanable funds has a positive slope. The main difference between this and a normal supply and demand figure is that the vertical axis is the interest rate rather than price; but, as we said, the interest rate can be thought of as the price of current consumption. As with any other market, the supply and demand curves can shift for a number of reasons. For our purposes, we only need to focus on one change: how Fed policy actions change the supply of loanable funds. Recall from chapter 11 that when the Fed purchases securities, they pay for those securities by crediting the reserves of the bank who sold the securities. The bank finds themselves with excess reserves and will extend additional loans; the fractional reserve banking systemwill lead the creation of multiple loans and deposits. INTEREST IN THE BIBLE? MATTHEW 25:27 “Then you ought to have put my money in the bank, and on my arrival I would have received my money back with interest.” Historically, the Christian church has condemned interest in most forms due to biblical prohibitions on usury. Some modern Christian commentators on economics argue that usury is different from interest that banks charge on business loans. Interest should only be considered usurious if it is charged on a poor loan to your needy neighbor. There is certainly much economic rationale to support this view. Were people unable to be paid interest, there would be less incentive to save and invest—given the universal nature of positive time preference. Further, in a modern inflationary world, one needs a positive interest rate just to receive back the same purchasing power that one loaned. Understanding the productivity of capital also seems to make actual business loans with no interest patently unfair. Why should I loan money to someone for investment purposes when he gets to keep all the profits? Further, there are always risks associated with business ventures; surely interest is a reasonable reward for business loans. Loans to your poor brother in need are an entirely different animal. As John Wesley said, “Earn all you can, give all you can, save all you can!” (For one Christian defense of interest on business loans, see North, Chapter 7.) r (%) Loanable Funds Market Q (#) Q 1 r * D LF S LF Figure 12.7, Loanable Funds Market. As with any market, the market for loanable funds features a downward sloping demand curve and an upward sloping supply curve. However, in the loanable funds market, the appropriate incentive to guide borrowers and lenders to allocate capital across time is the interest rate, which serves the same purpose as the price does in other markets.