Paradox of Real Interest Rate as Macroeconomic Equilibrating Price When Savings are Equated to ‘New’ Money

Abstract

We evaluate classical macroeconomic theory IS-LM model and expose the paradox of real interest rate (r) which equilibrates S (real goods and services produced and saved in the domestic economy) and I (investments) if the loanable capital is not coming only from real savings but investments can be financed through the money creation or 'money capital' generated either through the credit expansion in the banking system due to fractional reserves banking or through the open market operations by the government. If r is exogenous and lowered through monetary policy, I is expanded beyond S, which paradoxically require higher r to correct for these disbalances in macroeconomic sense. Economic and financial system should eliminate this exogenous influence on r, by separating money creation from r, so that r is left to play its equilibrating role in macroeconomic sense. Separation of r from interest rate on money is in line with prescribed prohibition of setting any fixed reward on money per se, and in general ex-ante setting of reward in productive endeavors which is also forbidden in Islamic jurisprudence. We show that classic macroeconomic theory does not expose the effect that fresh money has on saving and capital markets from the perspective of macroeconomic balance. Therefore, macroeconomic policy should concentrate on achievement of macroeconomic targets without lowering r as it is paradox to lower the return on capital and savings to promote economic growth as higher r on capital promotes investment. This is possible if ex-ante determination of reward on borrowed funds is adopted. However, the phenomena of fresh capital creation in the form of new money and its use in financing of investments should be rethought from macroeconomic perspective and overall social justice as real savings are not of equal opportunity cost as new money (capital)?