SECOND APPROXIMATION

THE TWO MARKET PRINCIPLESA. Principle of Clearing the Market

The rate of interest must be such as will clear themarket, that is, equalize supply and demand. That is, forevery time interval, the additions to some individuals’ in-comes caused by borrowing or selling must balance thedeductions from others caused by lending or buying.

B. Principle of Repayment

The loans must be equivalent in present worth to re-payments, or, more generally, the additions to any in-dividual’s income, brought about by borrowing or sell-ing, in some time intervals must be equivalent in presentworth to the deductions from his income in other timeintervals brought about by lending or buying.

Thus we see that the rate of interest is determined bytwo principles of investment opportunity as well as bytwo principles of impatience and by the two self-evidentmarket principles.

More briefly stated, the rate of interest is determinedso as (1) to make the most of opportunities to invest, (2)to make the best adjustment for impatience and (3) toclear the market and repay debts.

In short, the theory is thus one of investment oppor-tunity and human impatience, as well as exchange.

But while we have reached the two chief theoreticalfoundations of our subject, we are still, of course, far fromthe real world. The real world is vastly more complexthan the imaginary world described in this chapter. Inparticular, we still need to take account of risk. Thiswe shall do in the third approximation.

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