Goods are not in the real world produced by labor alone. Capital is another factor of production. We have described above the nature and significance of capital. Production can require more or less capital. Even in the most primitive circumstances some capital is needed for the survival of the workers during the production period. Modern production, with its very roundabout methods, needs much more capital. As production detours lengthen—say double—a double amount of capital must be in the hands of entrepreneurs. In a modern economy work is directed into roundabout methods of production by entrepreneurs, who borrow money in the form of credits from banks or in various forms from other money owners and spend that money on capital goods. If entrepreneurs should wish to double the length of the production detours, they would need to borrow a double amount of investable funds. The length of production detours depends, therefore, on the supply of and demand for investable funds.
Investable funds are directly or indirectly supplied by people who save money instead of spending it on consumption. How large is the supply of investable funds by savers? In a stationary economy, where changes are excluded by definition, we have to ask: how large is the total stock of savings? We do not ask how large is any addition to the stock by new saving. New savings are not necessary to uphold the status quo of production detours. The money received from the sale of finished products enables the entrepreneurs always again to acquire the capital goods or semi-finished products they need.
The amount of saving offered is, like every supply in a free economy, a function of the price, i.e. the interest rate. The question of how the supply curve for savings runs in general is controversial. Some people deny that the supply curve runs in the usual way upward to the right, which would indicate that more is saved and more savings offered at a higher interest rate. These authors assume that the curve runs vertically, meaning that the amount of savings is independent of the interest rate. This may or may not be the case. The important point here is that the curve never runs horizontally, i.e. that the supply is never unlimited.
Note that we are here dealing with the question of how much will be saved out of a given income. The further question, how changes in income call forth changes in savings, will be treated later when dealing with the changing economy. The latter question should never detract attention from the former.
What, on the other hand, will be the shape and level of the demand curve for credits, i.e. how much capital will be demanded at the various interest rates? In other words, how much interest will the entrepreneurs be prepared to pay for various amounts of capital?
Capital increases the productivity of the labor used in production. Suppose the length of detours of x years of a production in which y dollars are simultaneously invested is increased by 10 per cent of x years. They then obviously need simultaneously 110 per cent of y credits. Suppose that by such an increase of length the annual product increases by an amount equivalent to the output of three workers. Then, obviously, the entrepreneurs would be prepared to pay for the additional credit necessary an interest sum pro anno corresponding to the wages of three workers. If the next extension of production detours would again increase the product by the same amount, the entrepreneurs would again be prepared to pay interest corresponding to the wages of three workers. The demand curve would run horizontally. For every additional new quantity of capital the same interest would be offered.
But in reality every additional quantity of capital is less valuable than the former. Therefore the demand curve for credits does not run horizontally but downward to the right. So if the supply of capital increases, the interest rate must decline.
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