This is a first response to yesterday's debate on investment, saving, and all that. This is a huge subject, so I partition my response and begin with some aspect on the relationship between stocks and flows in the economy. My counterpart in the debate subscribes to the Keynesian view that stocks and portfolio choices dominate over flows and production and consumption choices. In Keynesian theory interest for instance is determined either by the interplay between the stock supply and stock demand for money or by the monetary authoritiy (and its control over the money supply). In neoclassical theory interest is determined solely by flows, by saving and investment as well as with changes in the supply of money and changes in hoardings. Post-Keynesians downplay the role of flows: Given the huge amount of assets accumulated in the past, flows like savings are not significant enough to impact on the investment and growth path of the economy (this argument is V. Chick's). In the traditional IS-LM model, still thaught to undergrads, for a given stock of money, each increase in aggregate demand and thus output is financed by dishoarding, by increasing interest rates and therewith the opportunity costs of hoalding money as a store-of-value. Again, for a given money supply, increasing interest rates increase velocity and the effective money supply (a flow!) which in turn allow demand components like investments to increase without any reduction in other components of spending. If the supply of money is a dependent variable (or made dependent by the monetary authority), the control of the level of aggragate activity in nominal terms is controlled by the banking system (or by policy).
But let me remain within the pure IS-LM model, without any banks or endogenous money. It suffices to reveal the stock view of Keynesian theory and the saving paradox. Here saving means simply non-spending, that is, saving is a leakage in the circular flow that reduces aggregate output, the demand for transaction demand of money, interest rates and thus the opportunity cost of holding money as an exit option in face of uncertainty. Thus, the act of saving finally decreases velocity. Of course, every neoclassical economists knew that given nominal rigididites, falling aggregate demand due to falling velocity reduces output and increases waste (unemployment). In neoclassical theory, increases in savings also reduce interest rates. It is also not denied that some of the money will be hoarded due to lower opportunity costs. But the flows saved by the households are assumed to form an excess supply of money capital, of means of finance, and to reduce the interest which signals a change in time preference. Firms do not need to know that preferences have changed. The system takes them by their profit motive so that they have only to maximize the present value of their activities: not only are financing costs lower, investment rankings adjust so that new capital intensive process climbes up the investment schedule while process that make use of old capital goods climb down. Accordingly, in addition to the excess supply of savings maintanence funds of inferior processes pour into the market to finance the formation of new capital. Note that Fisher's theory of interest is conceptualized for a progressive economy (as Lutz points out). Of course, a positive rate of time preference assures that interest is positive in stationarity, since accumulation breaks down as soon as the marginal productivity has fallen to a level equal to the social rate of time preference. In any way, interest is an intertemporal price relation, determined by productivity and thrift, that is, by technological knowledge, resource endowments, and preferences.
The backbone of all modern economic theory is the Arrow-Debreu economy. This model is static, but intertemporal choice is introduced by dated commodities (BTW Hayek's invention). Its a complete futures economy, so that interest is resolved in as many own rates of interest as there are markets. Interest is the spot price of a commoditiy over its futures price, for all commodities. Note, a positive interest means that the futures price is below that spot price which reflects the increase of the quantity of the commodity over time. And like general prices in general, interest rates coordinate independent individuals and bring their intertemporal plans into harmony. Only in a steady-state, with relative prices being constant over time, own rates are equal and is it legitimate to speak of the rate of interest. Note that AD economies are decentralized and disaggregated and thus the neoRicardian critique of early neoclassical interest theory does not apply.
In reality, of course, we have frictions and thus positive transaction costs. Money is a mean to reduce some of them. And also the loanable funds market is the system's response to such frictions. The capital market as we know it takes over most of the intertemporal exchanges in the economy. Own rates of interest are real for the few commodities traded on futures markets. The burden of intertemporal trade now rests on the money rates of interest, adjusted for risk and inflation expectations (and inflation volatility). But even though the market trades only present money for future money, money remains just a veil and real data still guides the system (also, as explained above, monetary phenomena have a short-run impact on interest rates). The major anti-Keynesian message of modern theory is that the use of money does not change to logic of the system or the nature of the economic problem. Money is rather an efficient tool to bring coordination about in a world with positive transaction costs. Since the system's optimal use of money implies nominal rigidities, changes in monetary demand for goods and services have real effects, of course.
In the real world economy, as epitomized in the AD economy, flows rules the roost. Real endowments are distributed among firms and households. Each productive asset contributes to (alternative) income flows. The job of the price system, including interest rates, is to guide the optimal choice among such investment opportunities. Thus it is the composition and level of endowments and the use of technological knowledge that generate income flows. Each asset with firms is valued according to the most valuable income stream generated by its use, discounted with the relvant money rate of interest which relates the productive opportunity set of each producer to all other investment opportunities in the economy. Fisher describes the market for loanable funds as a highway. Changes in money rates of interest induced disinvestment of some producers, releaving funds transmitted through the financial markets to others who are induced to invest since they face a higher rate of return over costs. The value of firms reflects the value added by the inherent properties of the firm (e.g. mangement) in the course of resource combination. Household transfers of assets, thus portfolio choices, change the relative price of such shares, bonds, etc.and thereby induces some firms to take up more money, and others to cut back investments. This is the invisible hand operating. But obviously, its all about flows!
