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9.4.4 Derived demand and time discount

An increase in saving sends two market signals to the business community.

Both must come into play if a change in intertemporal preferences is to get

translated successfully into corresponding changes in the economy’s multistage

production process. Changes in output prices together with changes in

the interest rate have consequences that affect the various stages of production

differentially. A non-perverse reallocation of resources in the face of

increased saving hinges critically on two principles: the principle of derived

demand and the principle of time discount. It is worth noting here that

perceived perversities in the saving–investment nexus of market economies

stem from an implicit denial of the second-mentioned principle. If derived

demand is taken to be the only principle in play, then it follows almost

trivially that the market cannot adapt to an increase in saving.

Increased saving means reduced current demand for consumer goods. (Of

course, for a growing economy in which both saving and consumption are

increasing, we would have to think in terms of changes in the relative rates of

increase. More rapidly increasing saving means a less rapidly increasing

demand for consumer goods.) A decrease in the demand for goods of the first

order – again, Menger’s terminology – has straightforward implications for

the demand for goods of the second order. The demand for coffee beans

moves with the demand for coffee. Menger’s Law prevails. More generally,

the demand for inputs that are in close temporal proximity to the consumable

output moves with the demand for that output. The demand for goods of the

second order is a derived demand. Under strict ceteris paribus conditions,

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which would entail no change in the rate of interest, derived demand would

be the whole story.

The more favourable credit conditions brought about by the increase in

saving is the basis for the rest of the story. A lower interest rate allows

businesses to carry inventories more cheaply. But how important is this

change in supply conditions? In gauging the relative changes in the demands

for goods of the first order and goods of the second order (coffee and coffee

beans), the time-discount effect is weak. Inventories of coffee beans are held

for only a short period of time, and consequently, the time-discount effect –

in this case, the reduced costs of carrying inventory – is trivial compared to

the derived-demand effect. The demand for coffee beans falls almost as much

as the demand for coffee. The strength of the time-discount effect is greater –

and increasingly greater – for the higher orders of goods. Consider, say, a

tenth-order good in the form of durable capital equipment. Testing facilities

and laboratory fixtures devoted to product development are good examples.

More favourable credit conditions could easily tip the scales toward creating

or expanding such a facility. In early stages of production, the time-discount

effect can more than offset the derived-demand effect.

Considerations of time discount draw resources into early stages of production.

Further, in gauging the profitability of early-stage activities, the

derived-demand effect itself can be augmenting rather than offsetting. Here,

the entrepreneurial element comes into play in a special way. What counts as

the relevant derived demand is not based on the current demand for goods of

the first order but rather on the anticipated demand at some future point in

time – a demand that may well be strengthened precisely because of the

accumulation of savings. The increased saving need not be taken as an

indication that the demand for consumables is permanently reduced. Rather,

savers are saving up for something. And entrepreneurs who best anticipate

just what they will be inclined to buy with their increased buying power stand

to profit from the intertemporal shift in spending.

The interplay between derived demand and time discount accounts for the

change in the pattern of resource allocation brought about by an increase in

saving. A judgement might be made that this account saddles the entrepreneurs

with a greater burden than they can bear. Yet those same entrepreneurial

skills were already in play in maintaining the intertemporal capital structure

before the increase in saving. That is, even in the absence of a change in

intertemporal preferences, market conditions throughout the economy are

continuously changing in every other respect – changes in tastes, in technology,

in resource availabilities. Entrepreneurs must continuously adapt to those

changes, while maintaining the temporal progression from early-stage to latestage

activities. An increase in saving simply requires that they make use of

those same skills – but under marginally changed credit conditions. A more

Figure 9.4 Time discount and derived demand

The derived-demand effect

dominates in the late stages

The time-discount effect

dominates in the early stages

M V = P (QC + Q2 + Q3 + Q4 + Q5 + Q6 + Q7 + Q8 + Q9 + Q10 )

plausible judgement would be that an economy unable to adapt to a change in

saving preferences is most likely unable to maintain a tolerable degree of

economic coordination even in the absence of such changes.

Figure 9.4 reproduces the equation of exchange with the investment sector

disaggregated into nine stages of production. The arrows indicate the direction

and relative magnitude of the change in the output quantities brought

about by an increase in saving. The reduction in the output of first-order

goods (QC) is echoed in the reduction in the output of second-through-fifthorder

goods (Q2, Q3, Q4 and Q5), the magnitude of the reduction attenuated

by the time-discount effect for the increasingly higher orders of goods. Starting

(in this illustration) with sixth-order goods, the time-discount more than

offsets the derived-demand effect. There are increases in the output levels of

the sixth and earlier stages of production (Q6, Q7, Q8, Q9 and Q10), the timediscount

effect becoming more dominant with increasingly higher-order goods.

The increased saving frees up resources, which are then allocated to the

different stages of production in a pattern governed by the more favourable

credit conditions. Grouping Q2 through Q10 together in Figure 9.4, we see that

overall investment rises as the current demand for consumable output (QC)

falls. Contrary to Keynes’s paradox of thrift, consumption and investment can

move in opposite directions. Attention to the intertemporal pattern of investment

allows us to resolve the paradox and to show how changes in investment

can be consistent with changes in saving behaviour. The wholesale neglect of

the pattern of investment underlay an early judgement by Hayek (1931) that

‘Mr. Keynes’s aggregates conceal the most fundamental mechanisms of

change’. It is significant that those fundamental mechanisms are set into

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motion by the supply and demand for loanable funds – because it was

loanable funds theory, a staple in the pre-Keynesians’ toolkit, that Keynes

specifically jettisoned.