Value & Capital, CHAPTER XI, Section 6

In this section, the final one of the chapter, the author summarizes his findings on the behavior of interest rates in an example economy.  In earlier sections he had defined two separate ways of constructing a simple economy having only one market rate of interest.  He argues that each of them has its advantages, so he proceeds to discuss them both in this section ("We shall therefore try to drive them for a while in double harness.")

In the first approach, there is a one-period interest rate (the "short rate") that is used as the unit from which the whole system of interest rates is built.  The author argues that "a system of nothing but short lending would break down in practice because many borrowers would desire the additional security that comes of borrowing for longer periods, and lenders would be prepared to grant them this security in return for a concession of rather higher rates of interest."

In the second example, interest rate is for funds loaned indefinitely.  The author notes that borrowers wanting to borrow for an extended length of time would be content with such a system.  In addition, those lenders "whose object is simply to derive a regular income from their capital, and have no thought of anything else" would likely find indefinite lending to be satisfactory.  In practice, the consideration by a lender of wanting his capital back for other uses will tend to expose the problems with indefinitely long lending.

As we have seen, the rate of interest which can be earned on a loan of any finite duration, by investing in undated debentures, is highly conjectural.  If there is a serious rise in the long-term rate of interest, the effective yield may be completely wiped out. But this is much less likely to happen if the security acquired has a definite maturity, even if it is disposed of at a different date from that at which it falls due.
    Thus lenders will always tend to reduce the risks to which they are subject if they can substitute shorter lending for longer lending ... In general we may suppose that they will be willing to make some sacrifice of interest (which may be great or small) in order to achieve greater security.

So short and medium-term interest rates will tend to be below the prevailing yield on indefinite loans;  the difference will correspond to a risk premium determined by "the estimate put upon the gain in security."  The prevailing yield on loans of indefinite duration "will lie below the current (long-term) market rate when that rate is expected to rise in the future, above it in the contrary case."  When the long-term rate is expected to be stable, "the short rate will lie below it to the extent of the normal risk-premium; when the long rate is expected to rise, the short rate will lie below it still further;  it is only when the long rate is expected to fall that the short rate may lie above the long rate."

These conclusions, based on the analysis of long-term rates, are consistent with those derived from the analysis of short rates.  The only difference is which of the rates (short or long) is the focus of expectations regarding future rate changes.  In both cases, the analysis of this section describes how a significant portion of the borrowing and lending will happen at rates different from the single market rate of interest, in order to accommodate the desire for greater security.  The author concludes the section (and hence the chapter) by noting that "there is a tendency for short and long rates to move in the same direction, but for the movement of short rates to have the larger amplitude."