We have said nothing so far about the role of capital or investment. Smith and Malthus were well aware of the importance of capital investment, but they did not think of it as being an independent factor, so it didn't play the key role in their theories. However, some later nineteenth century economists gave capital and investment a more central role. Later in the nineteenth century, economists learned more about the importance of capital and investment in promoting economic growth.
An economist named Nassau Senior made one of the key advances here. Senior wrote "That the powers of Labor, and of the other instruments that produce wealth, may be indefinitely increased by using their Products as the means of further production." This is a pretty clear statement that investment, in and of itself, increases output.
It may seem strange to say that someone discovered that investment increases output. From our point of view in the twentieth (almost twenty-first) century, that may seem too obvious to need discovery. But it was not obvious until Senior made it obvious by pointing it out.
But that is only half of the story. In economics, supply and demand are both part of the story. Senior told us why there is a demand for investment capital. There is a demand for investment capital because investment capital increases productivity. But what about supply? What limits the supply of investment capital?
Senior had an answer to that, too. The answer is known to economists as "time preference." Senior pointed out that people are impatient -- people "prefer" to have goods and services now rather than in the future. That's time preference: the time that people prefer is now, not in the future.
Turning that around, time preference limits the supply of investment funds. Because people prefer to enjoy goods and services now, and because investments only pay off in the future, people will not supply investment funds unless they are rewarded by more goods and services in the future than they can get now.
For example: John Doe wants to go into business, and asks James Roe for a loan to get started. If John offers to pay James 10% interest on the loan, then James will have 10% more goods and services next year than he can afford this year. That may be enough difference to overcome James' preference to have his goods and services now, and if so, James will supply the loan. Or it may not. If not, James will not supply the loan. In general, a supply of funds for investment will only be supplied if the interest rate is high enough to overcome the time preference of the lenders.
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