Fritz Machlup, The Rate of Interest as Cost Factor and as Capitalization Factor (1935)

Machlup’s six-section article compares two explanations of how interest-rate changes affect prices, production, and investment: interest as a production cost and interest as the factor used to capitalize expected future yields. His argument shifts attention from the limited reduction in current operating costs to the potentially substantial increase in the present value of durable equipment.

A comparative evaluation of this analysis and of that based on reasoning in terms of capitalization of future yields is the aim of this paper.

Section I isolates a reduction in the long-term interest rate available for productive investment. It distinguishes fixed equipment from working capital, and already committed funds from investments still open to decision. These distinctions determine whether cheaper credit merely improves a firm’s financial position or changes its incentives to produce and invest.

In our use of the terms, "old investments" designates all funds employed in effective investment at a given moment; while "new investment" is, at that moment, still subject to a plan, still to be decided upon.

Section II treats interest on existing fixed investment as an overhead charge. Even where contractual interest payments can be reduced, the resulting relief increases profits or decreases losses without changing the marginal costs governing output. Machlup rejects the assumption that prices must follow average total costs: continued production may minimize losses even when revenue does not cover all fixed charges. The distinction also specifies the argument’s time horizon.

Obviously, any reasoning which is concerned with "old" investment and "fixed" cost is, by definition, short-run analysis.

Sections III–IV acknowledge that interest on working capital enters marginal cost, but emphasize its small quantitative weight. If working capital turns over three times annually, a fall in interest from 5 to 4 percent reduces direct unit cost from $9.15 to $9.12, approximately 0.3 percent. Turnover and the initial rate constrain the saving, so a modest increase in wages or material prices can offset a proportionally large interest-rate reduction. Rising marginal costs and imperfectly elastic supplies of productive resources further limit the resulting expansion. Cheaper working-capital credit therefore offers little independent stimulus to production.

Section V identifies a more consequential application of cost reasoning: the choice of new fixed equipment. Lower interest can make capital-intensive methods economical, including machinery that saves labor but was previously too expensive to install. Interest must be considered alongside depreciation, obsolescence, and risk when comparing annual equipment charges with prospective savings. The scale of this substitution depends on available technical possibilities.

Section VI develops the capitalization explanation, which does not require technical innovation or a change in production methods. Given expected future yields, a lower discount rate raises equipment’s capitalized value. If that value initially equals construction cost, the increase creates an incentive to build additional equipment. A reduction from 5 to 4 percent raises the value of an infinitely durable instrument by 25 percent; for equipment lasting ten or twenty years, the corresponding gains exceed 5 and 9 percent. These effects are much larger than the working-capital cost savings.

The calculation must capitalize gross returns, including replacement allowances, over the equipment’s actual service life. Deducting depreciation does not justify treating every investment as a perpetual income stream. Longer-lived equipment consequently benefits more from a rate reduction, encouraging longer investment periods and connecting the analysis to business-cycle theory. Working capital expands in accompaniment to increased fixed investment. A concluding note allows that capitalization and cost reasoning can converge over sufficiently long periods for the community as a whole; the criticism concerns cost calculations within established firms.

The policy conclusion makes expected profitability indispensable to the investment stimulus.

If, however, no future profits are to be expected a reduction of the interest rate, even as a factor of capitalization, remains without any effect on prices and production.

Where low selling prices and inflexible labor and material costs eliminate prospective returns, a lower discount rate cannot create positive equipment values. Machlup thus explains both the potentially powerful sensitivity of durable investment to interest rates and the limits of cheaper credit when unfavorable cost-price relationships persist.