Gain-Loss Utility, Equilibrium and Interest Rates

Abstract

The author assesses the factors that determine market interest rates and the equilibrium conditions with respect to aggregate desired borrowings and savings. According to gain-loss utility, aggregate desired borrowings and savings are in equilibrium when market interest rates equal the aggregated income-growth expectations in the economy. Such equilibrium results in a steady-state economy but not necessarily full employment. In a monetary economy, bank-financed demand creates its own nominal supply with prices and employment being the unknown residuals. This means that agents spend money borrowed from banks in anticipation of future incomes. To achieve any level of output and employment, a monetary economy must bootstrap, whereby incomes must be anticipated ex-ante in order to be generated ex-post. The author finds that the supply of base money by the central bank may prevent interest rates in capital markets from converging with the aggregated income-growth expectations in the economy, resulting in fluctuations in nominal incomes, prices and employment.