Hi Dr. Herbener,
I’m working on a school project about the Japanese economy and I’m using your work on that subject. I’d like to present the ABCT but I have a question concerning it. Eventually interest rates have to go up either through monetary policy to slow down price inflation or through consumers expressing their time preferences.
But why exactly do the higher interest rates trigger the bust?
I’ve read that investment is less profitable but haven’t entrepreneurs already got their loan etc. I do not fully understand. And why do capital values collapse? Thank you
The capital value of an asset is the present value of future revenues it generates. The present value is found by discounting the future revenue by the rate of interest. So a higher interest rate reduces the present value of an asset.
The lower interest rate during the boom makes lengthening out the production structure more profitable. Once it has been lengthened out, then higher interest rates make shortening the production structure profitable. For example, during the boom, the increased demand for iron makes expanding the capital capacity in mining equipment more profitable. Iron producers increase their capital capacity. When the bust comes, the demand for iron dries up and the capital value of the capital capacity declines. Part of the investment of the boom proves to be mal-investment.
Thanks but I guess I have difficulties understanding how a change of the interest rate in general has effects the particular prices of already existing capital goods.
Imagine an entrepreneur during the boom who buys a machine that generates products worth $1000. If the interest rate is 2%, the present value of this machine is $10,000 – 2% = $9800. Let’s say the interest rate rises to 10%.
How does this increased interest rate decrease the present value of the mentioned type of machine? What are the changes in supply and demand that change the price?
People’s time preferences determine both the pure rate of interest and the amount of present money exchanged for future money. The same pure rate of interest is earned on every exchange of present money for future money, whether loans in the credit market or investments in production. If time preferences become higher, then interest rates will be higher and the amount of present money exchanged for future money will be smaller. In your example, since investors can earn 10 percent instead of 2 percent by lending into credit markets, they will reduce their demands for capital goods which reduces their prices. Capital goods prices will fall until investing in them also earn the 10 percent interest rate.