What is r*?
..and what is its link to money?
Money and its dynamics is not a trivial matter, as my previuos post suggests. A couple of important take-aways from that post are the following
That banks create one form of money, which in turn directly invalidates the I=S frameworks and Says law[1] but does not invalidate the value of money in and of itself.
That “every entity in the economy has obligations dependent on their cash flows, and collectively, their balance sheets form a network of promises, varying in size and stability depending on economic conditions.”
Hence, instead of considering IS/LM, I find it more useful start with the ideas of Wiksell given how the world works. Wiksell introduces the natural rate, which we define as the return on capital. By return on capital we mean how much profit companies are able to generate by acquiring additional “factors of production”. It should be clear that this is an important determinant in supply and demand for loans i.e. money. Note that such profits are highly depedandat on the macro economy and the demand for goods and services existing in it i.e. point 2 above.
Wiksell also introduces the money rates, which are the interet rates in the banking system which we can think of as the cost of capital. Notice the “s” at the end of rates, both the natural rate and the money rate will most likley differ between different balancesheets in the economy. We can of course aggregate across sectors or along other lines in the same way one has to do with consumers(who should also be thought of as balancesheets) while looking at the demand side in the economy mentioned above. This in turn leads to a loss in the precision of the mathematics, but that is the price(pun intended) one has to pay. Noone is stopping the reader or any other analysts from using his or her intution to fill in the gaps, a tool which futhermore is nessersary while considering the all imporntat animal spirits concept and its effects on the demand for goods and services.
Thats enough of disclaimers!
Wiksells logic is as simple as it is spot on. I almost quote [1],
If “…the natural rate is greater than the money rate (i.e. r* > i). In short, the return on capital is greater than its cost, it will be to the advantage of every entrepreneur to borrow funds from the bank and invest it in capital. That means I > S, i.e. finance investment will rise above savings as the bank, by its "magic wand", can create the deposits upon which borrowers can draw. In short, the money supply increases as a result.”
My interpretation of what is happeing is that businesses and banks meet in the banking system where they negotiate an interest rate. The business is considering its expected return on capital while the bank is considering the businesses reasonableness in thier expectations, i.e abaility to pay back the loans. This process is tightly interconnected with fact 2 above, both in that it depends on and effect it.
For example, if banks precive times to be good, it will make them more willing to lend, which in turn increases economic activity, in turn making it easier for corporations and consumers to fullfill thier commitments.
Today however it is my impressions that it is the ability to be able to roll that is more important in relation to most loans, since the capital market has turned into a refinancing mechanism rather then a capital raising mechanism, another important fact to consider thinking about money.