Value & Capital, CHAPTER XIII, Section 2

This section continues the exploration -- hinted at toward the end of the previous section -- into the nature of interest.  It begins by arguing that the way to "get nearest to the true nature of interest" is by "[considering] the relation between money and that type of security which comes nearest to being money, without quite being money."  It then goes on to state that this type of security is "the very short bill, a bill payable in the very near future, when that bill is regarded as perfectly safe from risk of default."  If there is some reason that such a security should sell at a discount (or "stand at less than its face value"), then this will be "a reason for the existence of pure interest."

The discussion then makes use of the model discussed earlier for analyzing dynamic economics in general and interest rates in particular.  Suppose, in this model, that markets are only open on Mondays, and suppose further that "the shortest currency of any bill is from one Monday to the next."  The natural question to ask is "Is it possible for such a bill to stand at a discount relatively to money?"  If there is nothing to stop an individual from converting all his surplus money into such bills and holding them during the week to earn interest, "then money has no superiority over bills, and therefore cannot stand at a premium relatively to bills."  (Or looked at another way, no one would have an incentive to sell such bills.)  "The rate of interest must be nil."

The discussion goes on to explore the incentive for holding money in such a model system, which is that converting money into bills requires going to the trouble of making a separate transaction.  The discussion goes on to note that the rate of interest on the given investment must reflect the inconvenience of the conversion transaction to the marginal lender (in other words, to the lender who causes the supply of loanable money to equal the demand).  This explanation is still incomplete, however.  For there to be some inconvenience in converting money to bills, it must be necessary to make the conversion transaction.  But making such a conversion is only necessary if people are not already holding bills.  This implies, for example, that people are not being paid in bills for things they sell, but instead are paid in money.  Conversely, some individuals to whom a borrower must make payments may not accept bills and instead insist on being paid in cash (again, perhaps requiring a conversion transaction).  Thus even though the bills may be regarded as having no default risk by those individuals who trade in them, there may still be an interest rate that is required to compensate lenders for the cost of investment.  The section finishes with this conclusion:

Thus the imperfect 'moneyness' of those bills which are not money is due to their lack of general acceptability;  it is this lack of general acceptability which causes the trouble of investing in them, and that causes them to stand at a discount.