Reply To: Q&A question follow-up about input prices.


Cwik is trying to isolate the effect of the suppression of the interest rate during the boom and its restoration during the bust on the profitability of production and thus, the liquidation of capital investment and reallocation of resources during the bust. In his model, he, therefore, assumes that input and output prices are constant (p. 5) to isolate the effect of movements in the interest rate on the present value calculation of asset prices and input prices. (In his model, the movement in input prices is accounted for in the movement of assets prices. Working capital appears in the numerator of the terms of the NPV equation for the price of fixed capital.) I think the general principle that his example shows is that asset prices must adjust downward relative to input prices to compensate for the rise in the interest rate in restoring profitability to production.

If we relax the assumption that input and output prices are constant, then even in Cwik’s model it is not necessary for input prices to rise. Whether or not they do would depend on output prices. And since the liquidation and reallocation process in the market restores the rate of return both to investment in working capital and fixed capital to the higher market interest rate, we know that at the end of the adjustment process output prices are higher relative to input prices.

Cwik is referring only to the effect of rising interest rates on working capital and fixed capital, others things the same, and he is insisting that this effect be taken into account in analyzing the liquidation and reallocation process.