Saturday, December 28, 2013

Interest Rates and Investment

Scott Sumner recently responded to a question from a commenter.  Dustin asked:

"An elementary question on the topic of interest rates that I’ve been unable to resolve via google:   Regarding Fed actions, I understand that reduced interest rates are thought to be expansionary because the resulting decrease in cost of capital induces greater investment. But I also understand that reduced interest rates are thought to be contractionary because the resulting decrease in opportunity cost of holding money increases demand for money.

One? Neither? Both? Little of each? Depends?"

Sumner claimed that it was difficult to answer.   He doubted whether most macroeconomists could give a sensible answer.   He made a remarkable claim:

"It’s not at all clear that lower interest rates boost investment (never reason from a price change.)  And even if they did boost investment it is not at all clear that they would boost GDP."

(On the other hand, he immediately followed that with the statement that open market purchases reduce short term nominal interest rates and boost nominal GDP.)

David Glasner found Sumner's response puzzling and accused Sumner of confusing a change in demand with a change in quantity demanded. 

The solution to that puzzle is simple.   Sumner has recently been drawing supply and demand diagrams for base money with 1/P on the vertical axis. Patinkin did the same ages ago.  A change in the interest rate shifts that demand curve. A change in the price level is a movement along the curve.

And so, if  we consider an exogenous decrease in the interest rate, the demand for money curve shifts to the right.  The new equilibrium price level is lower.   Given real output, that implies lower nominal GDP.

Most economists who teach introductory macro (as opposed to Macroeconomists, I suppose,) would deal with the question easily.   I would use it as an opportunity to discuss the difference between a change in demand and a change in quantity demanded using a Keynesian money market diagram–with the interest rate on the vertical axis.  In other words, I would answer the question much like Glasner.

If the quantity of money is given, and starting at equilibrium, a lower interest rate leads to a shortage of money. Those short on money sell securities, forcing the interest rate back up. The lower interest rate that might raise investment and nominal GDP is impossible. Unless of course, the quantity of money increased.

Now, consider a more classical framework. An increase in the supply of saving results in a lower interest rate.  At the old interest rate, desired saving is greater than desired investment.   The lower interest rate causes the quantity of saving supplied to decrease and the quantity of investment demanded to increase, making them again equal.  There is no direct impact on nominal GDP.   Nominal and real consumption decrease and nominal and real investment increase.  

However, this lower interest rate that coordinates saving and investment also raises the demand to hold money.   Sumner's (and Patinkin's) curve shifts right.  If the price level doesn't fall immediately, due to sticky prices (including wages,) the economy goes into recession. That could very well reduce investment (and saving, for that matter.) It also reduces the demand for money. (Sumner’s and Patinkin's curve shifts back left due to lower real income.)
In the long run, the price level falls. Real output recovers, and in the end, the interest rate is lower, real saving and real investment are both higher, but nominal GDP is lower.   Real and nominal consumption are both lower, but nominal investment is ambiguous.

Rather than thinking about a coordinating change in interest rates, we could think of interest rates being lowered through a price ceiling. The quantity of saving supplied decreases and quantity of investment demanded increases. The short side prevails. People are saving less and consuming more. Investment falls to match the quantity of saving supplied. No change in nominal GDP.   Real and nominal consumption are higher.   Real and nominal investment are lower.

The demand for money increases as before   The Sumner/Patinkin demand curve shifts right.  Some of the frustrated savers just accumulate money balances since they no longer find it attractive to fund investment by purchasing new debt and equity.    The economy goes into recession. This reduces real output and desired saving and investment. But, in the long run, the price level falls.

Given the price ceiling on “the” interest rate, we end up with more real consumption and less real investment than the start.   Nominal GDP is lower.   Nominal investment is lower, but nominal consumption is ambiguous.

But, of course, Sumner's real point is that an expansionary monetary policy involves an increase in the quantity of money.   It is not simply a lower interest rate generated by households saving more or tighter regulations on usury.

Is a lower interest rate expansionary?   As Yeager always would say, it depends on what caused it. 


  1. You can also just assume V (excluding ER) is relatively constant and leave money out of the graph. Put real rates (or preferably financial asset prices on the vertical axis) and the amount of financial assets exchanged for goods and services on the horizontal axis. Then you just have a simple indifference curve. A change in rates will cause a change in the quantity of financial assets exchanged for goods and services (i.e. an actual change in NGDP). Similarly, a change in expected NGDP (or the expected Wicksellian rate if you want to think about it that way) will cause a shift in the curve.

  2. Fast Payments and trusted Company - Invest $250 ROI $750 in 72 hours
    All payments are 100% Secure and guaranteed by Insta Forex Investments
    Fast Payments and trusted Company
    Plan A : Min $250 Max $2,499 ROI 300% of your deposited after 72 hours
    Plan B : Min $2,500 Max $24,999 ROI 400% of your deposited after 48 hours
    Plan C : Min $25,000 Max $250,000 ROI 600% of your deposited after 24 hours

    Guaranteed Profit

    Trusted Company

  3. In preparing my current blog article, I am visiting some economic blog sites that I have never been to before; and found your article and want to comment on it.

    Jesus Christ acting in dispensation, a concept presented by the Apostle Paul, in Ephesians 1:10, and meaning the oversight of all things economic and political, for the completion and perfection of every age, commenced the terminal phase of Liberalism with Ben Bernanke’s QE1.

    The years 2009 through 2103, was the zenith of the paradigm and age that featured the economic action of increasing inflationism, where there was a Great Swell in balance sheet of the US Federal Reserve, fiat wealth, such as World Stocks, VT, and M2 Money, as well as Total Credit, where the goal of monetary policy was investment gain, pursued by the world central banks acting in Global ZIRP and QE.

    Yet as Econometer author Satyajit Das relates Low rates also highlight the increasing risk of deflation and a severe contraction in economic activity. Low rates encourage mispricing of risk and create asset bubbles; low interest rates distort currency values and encourage volatile, short term, cross-border capital flows as investors seek higher returns.

    Economic life centered around the investor and investment choice, and carried impact in economic metrics such as Housing Starts, GDP Reports, Industrial Production, ADP Payroll, Construction Spending, Purchasing Manager’s Index, etc; the latter were not goals, but rather statistical attributes associated with risk-on investing.

    On October 23, 2013, Jesus Christ opened the first seal of the Scroll of end time events, and released the Rider on the White Horse, as seen in Revelation 6:1-2, to affect a global economic and political coup d etat. His ride over the world PIVOTED the world from paradigm and age of liberalism into that of authoritarianism.

    With the bond vigilantes calling the Benchmark Interest Rate, ^TNX, higher from 2.48%, economic action changed from one of inflationism to one destructionism, where there is the “dreaded experiences”, specifically the death of fiat money, the death of fiat wealth, economic deflation, nation state default on Treasury Debt, economic destruction, disregard for personal property, disregard for person property rights, and disregard for people as persons.

    The Great Economic Transformation is defined as the pivot from the paradigm and age of liberalism into that of authoritarianism, and it commenced with the failure of fiat wealth, that is World Stocks, VT, Nation Investment, EFA, and Global Financials, IXG, on the week ending January 17, 2014.

    There was a regime change from the banker regime with its rule of bankers and democratic nation states, where economic life centered on the investor and investment choice, to the beast regime with its rule of diktat of nannycrats in regional governance and totalitarian collectivism, where economic life is centered around the debt serf and debt servitude.

    The Benchmark Interest Rate, ^TNX, that is the cost of US Treasury Debt, TLT, was formerly the Means of Economic Inflationism. But, with its rise from 2.48%, on October 23, 2013, it commenced the failure of trust in the monetary policies of credit stimulus of the Creature from Jekyll Island, and the economic policies of investment choice of democratic nation states. Now, The Interest Rate on the US Ten Year Note, ^TNX, is the Means of Economic Destructionism, establishing economic deflation and economic recession, terminating economic inflation and economic growth, and thus terminating the paradigm and age of liberalism, and birthing that of authoritarianism.

    Perhaps one might consider visiting my blog next week and commenting on my forthcoming article.

  4. Bitcoin Instant Growing - 1800% after 12 Hours
    We have teamed up with a select group of Private companies and investors to offer 100% principal investment insurance for all of our investors. This group has agreed to insure all principal deposits for a share of our monthly earnings. This allows our group to diversify their investment portfolio and create a risk free, highly attractive, and profitable investment opportunity for our investors.
    Invest Now
    Investment Insurance

  5. Investment should always be done in a very correct way, if we do investment without properly understanding things or at correct place then we are likely to get into a tangle. I am fairly happy with my current selection which is of OctaFX broker, it is a superb company with having 50% bonus on deposit, it is also use able, so that makes it pretty special and allows me to be very much comfortable with doing all the stuff I wish to.