John Maynard Keynes
The General Theory of Employment, Interest and Money

Appendix to Chapter 14. Appendix on the Rate of Interest in Marshall’s “Principles of Economics”, Ricardo’s “Principles of Political Economy”, and elsewhere


THERE is no consecutive discussion of the rate of interest in the works of Marshall, Edgeworth or Professor Pigou, — nothing more than a few obiter dicta. Apart from the passage already quoted above (p. 139) the only important clues to Marshall’s position on the rate of interest are to be found in his Principles of Economics (6th edn.), Book VI. p. 534 and p. 593, the gist of which is given by the following quotations:

“Interest, being the price paid for the use of capital in any market, tends towards an equilibrium level such that the aggregate demand for capital in that market, at that rate of interest, is equal to the aggregate stock forthcoming there at that rate. If the market, which we are considering, is a small one — say a single town, or a single trade in a progressive country — an increased demand for capital in it will be promptly met by an increased supply drawn from surrounding districts or trades. But if we are considering the whole world, or even the whole of a large country, as one market for capital, we cannot regard the aggregate supply of it as altered quickly and to a considerable extent by a change in the rate of interest. For the general fund of capital is the product of labour and waiting; and the extra work,[2] and the extra waiting, to which a rise in the rate of interest would act as an incentive, would not quickly amount to much, as compared with the work and waiting, of which the total existing stock of capital is the result. An extensive increase in the demand for capital in general will therefore be met for a time not so much by an increase of supply, as by a rise in the rate of interest; [3] which will cause capital to withdraw itself partially from those uses in which its marginal utility is lowest. It is only slowly and gradually that the rise in the rate of interest will increase the total stock of capital” (p. 534).

“It cannot he repeated too often that the phrase ‘the rate of interest’ is applicable to old investments of capital only in a very limited sense.[4] For instance, we may perhaps estimate that a trade capital of some seven thousand millions is invested in the different trades of this country at about 3 per cent net interest. But such a method of speaking, though convenient and justifiable for many purposes, is not accurate. What ought to be said is that, taking the rate of net interest on the investments of new capital in each of those trades [i.e. on marginal investments] to be about 1 per cent; then the aggregate net income rendered by the whole of the trade-capital invested in the various trades is such that, if capitalised at 33 years’ purchase (that is, on the basis of interest at 3 per cent), it would amount to some seven thousand million pounds. For the value of the capital already invested in improving land or erecting a building in making a railway or a machine, is the aggregate discounted value of its estimated future net incomes [or quasi-rents]; and if its prospective income-yielding power should diminish, its value would fall accordingly and would be the capitalised value of that smaller income after depreciation” (p. 593).

In his Economics of Welfare, (3rd edn.), p. 163, Professor Pigou writes: “The nature of the service of ‘waiting’ has been much misunderstood. Sometimes it has been supposed to consist in the provision of money, sometimes in the provision of time, and, on both suppositions, it has been argued that no contribution whatever is made by it to the dividend. Neither supposition is correct. ‘Waiting’ simply means postponing consumption which a person has power to enjoy immediately, thus allowing resources, which might have been destroyed, to assume the form of production instruments.[5] ... The unit of ‘waiting ‘ is, therefore, the use of a given quantity of resources[6] — for example, labour or machinery — for a given time. ... In more general terms we may say that the unit of waiting is a year-value unit, or, in the simpler, if less accurate, language of Dr. Cassel, a year-pound. ... A caution may be added against the common view that the amount of capital accumulated in any year is necessarily equal to the amount of ‘savings’ made in it. ‘This is not so, even when savings are interpreted to mean net savings, thus eliminating the savings of one man that are lent to increase the consumption of another, and when temporary accumulations of unused claims upon services in the form of bank-money are ignored; for many savings which are meant to become capital in fact fail of their purpose through misdirection into wasteful uses.”[7]

Professor Pigou’s only significant reference to what determines the rate of interest is, I think, to be found in his Industrial Fluctuations (1st edn.), pp. 251-3, where he controverts the view that the rate of interest, being determined by the general conditions of demand and supply of real capital ‘ lies outside the central or any other bank’s control. Against this view he argues that: “When bankers create more credit for business men, they make, in their interest, subject to the explanations given in chapter xiii. of part i.,[8] a forced levy of real things from the public, thus increasing the stream of real capital available for them, and causing a fall in the real rate of interest on long and short loans alike. It is true, in short, that the bankers’ rate for money is bound by a mechanical tie to the real rate of interest on long loans; but it is not true that this real rate is determined by conditions wholly outside bankers’ control.”

My running comments on the above have been made in the footnotes. The perplexity which I find in Marshall’s account of the matter is fundamentally due, I think, to the incursion of the concept “interest”, which belongs to a monetary economy, into a treatise which takes no account of money. “Interest” has really no business to turn up at all in Marshall’s Principles of Economics, — it belongs to another branch of the subject. Professor Pigou, conformably with his other tacit assumptions, leads us (in his Economics of Welfare) to infer that the unit of waiting is the same as the unit of current investment and that the reward of waiting is quasi-rent, and practically never mentions interest, — which is as it should be. Nevertheless these writers are not dealing with a non-monetary economy (if there is such a thing). They quite clearly presume that money is used and that there is a banking system. Moreover, the rate of interest scarcely plays a larger part in Professor Pigou’s Industrial Fluctuations (which is mainly a study of fluctuations in the marginal efficiency of capital) or in his Theory of Unemployment (which is mainly a study of what determines changes in the volume of employment, assuming that there is no involuntary unemployment) than in his Economics of Welfare.


The following from his Principles of Political Economy (p.511) puts the substance of Ricardo’s theory’ of the Rate of Interest:

“The interest of money is not regulated by the rate at which the Bank will lend, whether it be 5, 3 or 2 per cent, but by the rate of profit which can be made by the employment of capital, and which is total independent of the quantity or of the value of money. Whether the Bank lent one million, ten millions, or a hundred millions, they would not permanently alter the market rate of interest; they would alter only the value of the money which they thus issued. In one case, ten or twenty times more money might be required to carry on the same business than what might be required in the other. The applications to the Bank for money, then, depend on the comparison between the rate of profits that may he made by the employment of it, and the rate at which they are willing to lend it. If they charge less than the market rate of interest, there is no amount of money which they might not lend; — if they charge more than that rate, none but spendthrifts and prodigals would be found to borrow of them.”

This is so clear-cut that it affords a better starting-point for a discussion than the phrases of later writers who, without really departing from the essence of the Ricardian doctrine, are nevertheless sufficiently uncomfortable about it to seek refuge in haziness. The above is, of course, as always with Ricardo, to be interpreted as a long-period doctrine, with the emphasis on the word “permanently” half-way through the passage; and it is interesting to consider the assumptions required to validate it.

Once again the assumption required is the usual classical assumption, that there is always full employment; so that, assuming no change in the supply curve of labour in terms of product, there is only one possible level of employment in long-period equilibrium. On this assumption with the usual ceteris paribus, i.e. no change in psychological propensities and expectations other than those arising out of a change in the quantity of money, the Ricardian theory is valid, in the sense that on these suppositions there is only one rate of interest which will be compatible with full employment in the long period. Ricardo and his successors overlook the fact that even in the long period the volume of employment is not necessarily full but is capable of varying, and that to every banking policy there corresponds a different long-period level of employment; so that there are a number of positions of long-period equilibrium corresponding to different conceivable interest policies on the part of the monetary authority.

If Ricardo had been content to present his argument solely as applying to any given quantity of money created by the monetary authority, it would still have been correct on the assumption of flexible money-wages. If, that is to say, Ricardo had argued that it would make no permanent alteration to the rate of interest whether the quantity of money was fixed by the monetary authority at ten millions or at a hundred millions, his conclusion would hold. But if by the policy of the monetary authority we mean the terms on which it will increase or decrease the quantity of money. i.e. the rate of interest at which it will, either by a change in the volume of discounts or by open-market operations, increase or decrease its assets — which is what Ricardo expressly does mean in the above quotation — then it is not the case either that the policy of the monetary authority is nugatory or that only one policy is compatible with long-period equilibrium; though in the extreme case where money-wages are assumed to fall without limit in face of involuntary unemployment through a futile competition for employment between the unemployed labourers, there will, it is true, be only two possible long-period positions — full employment and the level of employment corresponding to the rate of interest at which liquidity-preference becomes absolute (in the event of this being less than full employment.). Assuming flexible money-wages, the quantity of money as such is, indeed, nugatory in the long period; but the terms on which the monetary authority will change the quantity of money enters as a real determinant into the economic scheme.

It is worth adding that the concluding sentences of the quotation suggest that Ricardo was overlooking the possible changes in the marginal efficiency of capital according to the amount invested. But this again can be interpreted as another example of his greater internal consistency compared with his successors. For if the quantity of employment and the psychological propensities of the community are taken as given, there is in fact only one possible rate of accumulation of capital and, consequently, only one possible value for the marginal efficiency of capital. Ricardo offers us the supreme intellectual achievement, unattainable by weaker spirits, of adopting a hypothetical world remote from experience as though it were the world of experience and then living in it consistently. With most of his successors common sense cannot help breaking in — with injury to their logical consistency.


A peculiar theory of the rate of interest has been propounded by Professor von Mises and adopted from him by Professor Hayek and also, I think, by Professor Robbins; namely, that changes in the rate of interest can be identified with changes in the relative price levels of consumption-goods and capital-goods.[9] It is not clear how this conclusion is reached. But the argument seems to run as follows. By a somewhat drastic simplification the marginal efficiency of capital is taken as measured by the ratio of the supply price of new consumers’ goods to the supply price of new producers’ goods.[10] This is then identified with the rate of interest. The fact is called to notice that a fall in the rate of interest is favourable to investment. Ergo, a fall in the ratio of the price of consumers’ goods to the price of producers’ goods is favourable to investment.

By this means a link is established between increased saving by an individual and increased aggregate investment. For it is common ground that increased individual saving will cause a fall in the price of consumers’ goods, and, quite possibly, a greater fall than in the price of producers’ goods, hence, according to the above reasoning, it means a reduction in the rate of interest which will stimulate investment. But, of course, a lowering of the marginal efficiency of particular capital assets, and hence a lowering of the schedule of the marginal efficiency of capital in general, has exactly the opposite effect to what the argument assumes. For investment is stimulated either by a raising of the schedule of the marginal efficiency or by a lowering of the rate of interest. As a result of confusing the marginal efficiency of capital with the rate of interest, Professor von Mises and is disciples have got their conclusions exactly the wrong way round. A good example of a confusion along these lines is given by the following passage by Professor Alvin Hansen: [11] “It has been suggested by some economists that the net effect of reduced spending will be a lower price level of consumers’ goods than would otherwise have been the case, and that, in consequence, the stimulus to investment in fixed capital would thereby tend to be minimised. This view is, however, incorrect and is based on a confusion of the effect on capital formation of (1) higher or lower prices of consumers’ goods, and (2) a change in the rate of interest. It is true that in consequence of the decreased spending and increased saving, consumers’ prices would be low relative to the prices of producers’ goods. But this, in effect, means a lower rate of interest, and a lower rate of interest stimulates an expansion of capital investment in fields which at higher rates would be unprofitable.”

Author’s Footnotes

1. It is to be noticed that Marshall uses the word “capital” not “money” and the word “stock” not “loans”; interest is a payment for borrowing money, and “demand for capital” in this context should mean “demand for loans of money for the purpose of buying a stock of capital-goods”. But the equality between the stock of capital-goods offered and the stock demanded will be brought about by the prices of capital-goods, not by the rate of interest. It is equality between the demand and supply of loans of money, i.e. of debts, which is brought about by the rate of interest.

2. This assumes that income is not constant. But it is not obvious in what way a rise in the rate of interest will lead to “extra work”. Is the suggestion that a rise in the rate of interest is to be regarded, by reason of its increasing the attractiveness of working in order to save, as constituting a sort of increase in real wages which will induce the factors of production to work for a lower wage? This is, I think, in Mr. D. H. Robertson’s mind in a similar context. Certainly this “would not quickly amount to much”; and an attempt to explain the actual fluctuations in the amount of investment by means of this factor would be most unplausible, indeed absurd. My rewriting of the latter half of this sentence would be: “and if an extensive increase in the demand for capital in general, due to an increase in the schedule of the marginal efficiency of capital, is not offset by a rise in the rate of interest, the extra employment and the higher level of income, which will ensue as a result of the increased production of capital-goods, will lead to an amount of extra waiting which in terms of money will be exactly equal to the value of the current increment of capital-goods and will, therefore, precisely provide for it.”

3. Why not by a rise in the supply price of capital-goods? Suppose, for example, that the “extensive increase in the demand for capital in general” is due to a fall in the rate of interest. I would suggest that the sentence should be rewritten: “In so far, therefore, as the extensive increase in the demand for capital-goods cannot be immediately met by an increase in the total stock, it will have to be held in check for the time being by a rise in the supply price of capital-goods sufficient to keep the marginal efficiency of capital in equilibrium with the rate of interest without there being any material change in the scale of investment; meanwhile (as always) the factors of production adapted for the output of capital-goods will be used in producing those capital-goods of which the marginal efficiency is greatest in the new conditions.”

4. In fact we cannot speak of it at all. We can only properly speak of the rate of interest on money borrowed for the purpose of purchasing investments of capital, new or old (or for any other purpose).

5. Here the wording is ambiguous as to whether we are to infer that the postponement of consumption necessarily has this effect, or whether it merely releases resources which are then either unemployed or used for investment according to circumstances.

6. Not, be it noted, the amount of money which the recipient of income might, but does not, spend on consumption; so that the reward of waiting is not interest but quasi-rent. This sentence seems to imply that the released resources are necessarily used. For what is the reward of waiting if the released sources are left unemployed?

7. We are not told in this passage whether net savings would or would not be equal to the increment of capital, if we were to ignore misdirected investment but were to take account of “temporary accumulations of unused claims upon services in the form of bank-money”. But in Industrial Fluctuations (p. 22) Prof. Pigou makes it clear that such accumulations have no effect on what he calls “real savings”.

8. This reference (op. cit. pp. 129-134) contains Prof. Pigou’s view as to the amount by which a new credit creation by the banks increases the stream of real capital available for entrepreneurs. In effect he attempts to deduct “from the floating credit handed over to business men through credit creations the floating capital which would have been contributed in other ways if the banks had not been there”. After these deductions have been made, the argument is one of deep obscurity. To begin with, the rentiers have an income of 1500, of which they consume 500 and save 1000; the act of credit creation reduces their income to 1300, of which they consume 500 - x and save 800 + x; and x, Prof. Pigou concludes, represents the net increase of capital made available by the act of credit creation. Is the entrepreneurs’ income supposed to be swollen by the amount which they borrow from the banks (after making the above deductions)? Or is it swollen by the amount, i.e. 200, by which the rentiers’ income is reduced? In either case, are they supposed to save the whole of it? Is the increased investment equal to the credit creations minus the deductions? Or is it equal to x? The argument seems to stop just where it should begin.

9. The Theory of Money and Credit, p. 339 et passim, particularly p. 363.

10. If we are in long-period equilibrium, special assumptions might be devised on which this could be justified. But when the prices in question are the prices prevailing in slump conditions, the simplification of supposing that the entrepreneur will, in forming his expectations, assume these prices to be permanent, is certain to be misleading. Moreover, if he does, the prices of the existing stock of producers’ goods will fall in the same proportion as the prices of consumers’ goods.

11. Economic Reconstruction, p. 233.