Entrepreneurial Calculation and the Interest Rate
This Demonstration shows the net present value (NPV) of two investments valued at different interest rates. To calculate the NPV an entrepreneur must estimate future rates of interest and the size of future cash flows. Explore the range of real returns for each investment in the case that the entrepreneur has made errors in estimating these parameters. Chose between long-term, short-term, or annuity style investments.
Rothbard and others in the Austrian school of economics have contended that the low interest rates resulting from expansionary monetary policy ultimately result in an accumulation of poorly judged investments in the economy due to entrepreneurial miscalculation. According to their theory, the result is an excess of longer-term investments that become unprofitable and require liquidation when interest rates inevitably rise.
Compounding this entrepreneurial calculation issue are errors on the part of the entrepreneur that are inevitable when making predictions of future outcomes. The errors considered here are the predictions of future interest rates and the size of future cash flows. Given two projects with differing cash flows and a specified amount of error in the forecast of both future rates and cash flows, the probability that the entrepreneur will choose the investment with the lower real return increases in lower interest rate environments.
Snapshot 1: the value of long-term investment decreases more quickly than that of short-term investments as interest rates rise
Snapshot 2: the impact of an entrepreneur misjudging future discount rates or cash flows shown by the error bands around each investment
Snapshot 3: at lower rates, differences in the NPV of long-term investments and annuities appear larger than at higher rates; in lower rate environments investment decisions appear clearer and more obvious, while the real returns from these investments are more uncertain and sensitive to error