ECON430-Topic #3: Interesting Interest Rates

The main idea behind monetary policy–either discretionary or rules based–depends on interest rates being able to impact output. As the Economist recently noted, it appears that interest rates have not affected investment–and therefore output. The author of the paper cited in the article is quoted as saying

Companies tend to dwell too much on recent experience when deciding how much to invest and too little on how changing circumstances may affect future returns. This is particularly true in difficult times. Appealing opportunities may exist, and they may be all the more attractive because of low interest rates. That should matter—but the data suggest it does not.

This implies that there is a behavioral foundation at the heart of investment that varies from rational expectations theory. Now, if the theories that predict investment should rise made correct predictions, then it might not matter what the model looks like. However, when the models are not making good predictions, you may want to consider looking at your assumptions.

Since we have been at (or close) to the zero-lower bound across the world in the last several years, inflation has not accelerated as most central banks might have hoped. Should another shock occur, could central banks do much to offset this shock? Or would we be forced to rely on fiscal policy to give economies the boost they need. Not to mention that economists have been wrong time and again when looking at interest rates, and doomsday predictions of inflation have also been far off the mark.

There are other problems that have surfaced in Switzerland and the Euro zone which led the Swiss National Bank to fix their exchange rate to the Euro at a rate of 1.20 in order to protect their economy. they have been maintaining this peg for some time. However, there is a movement for the SNB to hold 1/5 of their assets in gold, which might limit their ability to maintain their peg. In the U.S., there is another movement to fight the Fed’s power and the narrative that they have done a good job since their founding. The desire to return to the gold standard has risen in recent years, but as mentioned in the Economist, the gold standard has its own serious flaws.

Questions you might consider

  • What might alternative behavioral foundations suggest about monetary policy? The rules and heuristics that firms and central bankers use might be flawed, and therefore in order to have effective monetary policy you would need to understand these behavioral foundations. Look for more research or writing on the behavioral interpretation of interest rates and economic activity.
  • Do you believe there is a danger of the world facing a large negative shock (like the breakup of the Euro) which could lead to global deflation and depression? If so, what could central banks do in the event of one of these shocks? What would happen in a global financial crisis if we were on the gold standard? You could look at the case of Switzerland and the arguments made about why the central bank might not want to have its assets held as gold.
  • What are other explanations of why monetary policy might not have been having the intended effects of raising output? Could there be an effect of having central banks deny that they want higher inflation when they actually probably want higher inflation rates than they currently have? Is there a deflationary bias among central bankers? Could this be part of the problem faced by central banks?

7 thoughts on “ECON430-Topic #3: Interesting Interest Rates”

  1. There are several explanations as to why monetary policy might not be having the intended effect on output. Financial market uncertainty, increased liquidity preferences, higher reserves, and a generally unfriendly climate for investments may all have a hand in dampening output. First and foremost, inflation needs to be present in the event of an increase in economic output. This is so that deflationary pressures do not slow down an economy on the verge of expanding. Secondly, large world economies need to set the standard when it comes to inflation expectations and that is the role of the central banks. Central bankers denying inflation creates a self fulfilling prophecy because inflation is about expectations (read Fisher effect). If the central banks of the world can influence expectations, which we know they can, it falls on them to accept this responsibility.
    The Chinese economy is one of the most important economies in the world. Even their mighty economy is showing cracks. A one percent decrease in producer prices alongside a corresponding decrease in output coupled with disinflation is potentially catastrophic, [2]. Policy makers in China now have to face the increase in corporate debt that was caused by such a large credit expansion in the country since 2008, [1]. With slowing growth and disinflation, the burden of that debt will be increased. The Chinese can be thankful that the yuan has halted its appreciation this year, keeping the price of imports low, [3]. How does this tie back into monetary policy? It goes to show that lowering interest rates globally will not spur investment, because retrospective actions in economies are becoming increasingly important to future decisions.

    Works Cited


  2. The Fed is ending its bond-buying program as interest rates have been close to zero for some time now. Investors are waiting for interest rates to rise again but have repeatedly pushed back their prediction date for a hike in rates. The Fed wants to increase the inflation rate from its current 1.6% to its 2% goal but the problem is that the Fed is having a hard time of getting there because of their lack of commitment. The Fed has been pumping money into the system for some time now and has been promoting spending and investment. With the Fed stopping their bond buy-back program, people don’t believe that inflation will increase, in fact, they are holding onto their money with the thought that there will be a deflationary period coming after the halt in the program. However, some investors believe the Fed will hold rates low for as long as they can.
    With the Fed starting its two day meeting today, there is speculation that they will try and maintain low interest rates for a while in attempt to get the inflation rate up to 2%. This is due to China’s struggling economy and the problems with the Euro. More news will come out in the next two days, but we can see that the Fed is trying to fix their “commitment issues” by promoting higher inflation.

  3. When looking at recent consumer behavior regarding investing and spending, it is easy to see just how flawed the implicit assumption of rational decision-making can be. With currently low interest rates, by the fundamentals of economics, the assumption is that it becomes cheaper for businesses and households to borrow. Therefore, people will invest and borrow more, helping to increase consumption and spark economic growth. But the fact is, people are just not abiding to this traditional monetary policy assumption, and are not acting as they should or ‘expected’. According to Bloomberg, the U.S. savings rate has doubled since 2007 to 5.4% in September. Over the last six years, Americans have been focusing their efforts on cutting down debt, and have trimmed down $1.5 trillion in mortgage debt and $139.4 billion in credit card and other debt. Additionally, though housing prices have seen moderate improvements, what is important to note is the increase in demand for rentals, driving rental prices up 16% in metro areas. Since all of this is happening even with interest rates at extreme lows, this suggests that investment may have more of a behavioral foundation. What these numbers indicate, is that people may feel reluctant to buy because they fear facing debt or similar scenarios to 2007. This concept of current or future consumer behavior being influenced by past events can be explained by a psychological term called the “availability bias.” In short, consumers today remember how irresponsible spending led them into trouble in the past, so it should be no surprise if they may be a little hesitant to spend now, regardless of how low interest rates may be.

    Another tool used to measure consumer behavior is the Consumer Confidence Index. The CCI explains the degree of optimism on the state of the economy that consumers are expressing through their activities of savings and spending. The more confident people feel about the economy and their jobs and income, the more likely they are to spend money. Consumer confidence fell sharply to 86 from 93.4, after rising four straight months and hitting a seven-year high in August.

    When it appears lower interest rates are not having the assumed impact on consumption, it suggest that the behavioral foundation of investing may be a lot stronger than previously thought. Since it is hard to ever fully get a handle on consumer behavior, maybe fiscal policy aimed at sparking consumer confidence would be more appropriate.

  4. The EU seems to be in a very fragile state it seems. Rumors of Belgium, Catalonia, and Scotland all leaving the Euro because they are tired of paying for others in their crisis hit countries. These small movements could be a stepping stone to something bigger, as the whole country might decide to follow suit. The breaking of the Euro might not have to be the eminent doom of the global economy if maybe countries such as France, Germany, and the UK secede from the Euro and form their own union and leave the crisis plagued countries in a union that promotes growth for them without bringing down the bigger countries. We might be able to break extended deflation and depression but in the short run it would be impossible to dodge deflation/depression in this matter.
    Central Banks would have to anticipate this by backing the deposits with reserve requirements that are stricter than normal deflation numbers due to the size of the EU and the ambiguity that surrounds the breaking of globally recognized union. The United States Central Bank might have to enable fiscal policy along with monetary policy to fight the crisis. Fiscal policy would help stimulate the velocity of money and monetary policy would keep deflation out of the equation.
    I would hope to not be on a gold standard during a global financial crisis because gold would have to flow out of the country faster than imports would come. If we were to remain on the gold standard then we would fighting tough times of deflation and depression as the United States runs on floating exchange rates. Cases like Switzerland, where the exchange rates are managed/pegged, they can combat deflation and maintain competitiveness.

  5. Economists today can generally agree that GDP in the long run will be relatively stable. However, it is the short run GDP and the monetary policy of central banks that have economists on opposing ideals. Monetary policy should increase output in the short run because of price and wage stickiness, however in recent years some believe monetary policy has not affected output, which leads many to the question, why?

    Quantitative easing, while theoretically sound, may not work as well in actuality and probably won’t keep working if carried out many times. The banks that the Fed is lending money to, the money which is ultimately supposed to boost the economy and stimulate GDP, are scared of another financial crisis. Although this is a legitimate concern, it means that they are holding the money they are getting from the Fed, therefore the money isn’t being pumped back into the economy, it’s just sitting in banks. If banks aren’t making loans then the likelihood of output increasing is much slimmer. Each time quantitative easing has been carried out, the GDP gain from it has decreased, showing that although it may have the effect it initially was intended to have, it is becoming less effective each time.

    Lags are another large reason monetary policy may not affect output as expected. Lags are difficult to predict in the economy and therefore the Fed may be enacting monetary policy too soon or too late. This creates a shift of the intended benefits because if they policy doesn’t affect the economy at the right time it may hurt output or at least not have as strong of an effect as it should have.

    Monetary policy is put in place to ultimately affect output and help the economy. However it is a very delicate science and may not always be able to act as it is intended.

  6. Clearly the current trends taking place in the market are not supporting the generally accepted theories about interest rates. Not only are the changes in interest rate not affecting investment as predicted, but also the interest rate itself is widely difficult to predict. This explicitly goes against the assumption that individuals will act rationally. However, one school of thought is being disregarded in this discussion so far. As a reminder, Keynes stated that individuals keep a “normal” interest rate in mind and use it as a benchmark for what will occur in the market. If the interest rate is currently higher than their perceived normal rate, the interest rate will need to decreases, prices will go up, and the individual would like to hold more bonds. The opposite is true if the current interest rate is lower than their perceived normal rate. If this is this is what the current market actually looks like, and the assumption of rationality is dropped, then a zero-bound policy can lead to a stalemate. If the U.S. is already at a zero interest rate, or incredibly close to one, it should be clear that interest rates have nowhere to go except up. Prices would be likely to fall and people would choose to hold more money. This would further keep the low interest rate and cause for the slowing of growth. Given this, perhaps the Federal Reserve should give up on the zero-bound policy. Individuals could have normal rates above or below zero, which would allow for some demand in bonds, which would stimulate activity. Theoretically, the negative interest rate wouldn’t hold for long, and activity would be a possibility again.

  7. If the Euro were to breakup, this would not only affect the individual European countries, but will also have global repercussions. With increasing pressures on the Euro from countries mismanaging their debt and putting the burden on the healthy, thriving countries, it is become an increasingly likely possibility that countries soon start to drop out of the Eurozone. The situations in Greece, Spain and Portugal clearly shows the risks of a monetary union, and now with Cyprus struggling, it is becoming even more evident. If a country were to be forced, or backed, out of the EU it could potentially have three effects. The first and fairly obvious result would the country’s currency would immediately devalue against the euro (especially if they were forced out) and could send the country into a depression. The second possibility if that if countries’ currencies begin to devalue, other countries’ goods will become more expensive for them affecting many of the EU’s primary trading partners [1]. This is when the effects of the Eurozone breaking up will begin to have a global effect [2]. The third possibility, and probably the worst, is that investors will begin to lose confidence in the euro. What makes the EU successful is that investors do not believe that countries will back out; however, if countries do start to leave, it effects the credibility of the euro, causing people to potentially start selling assets valued in euros for other currencies. This will begin to decrease the value of the euro which would have huge global supply shock implications [3]. In the event that this were to happen, the European central bank can take some measures to mitigate some of these risks. The main focus that they would have is to offset the effects on the euro by trying to keep the money supply constant so that it does not float against other currencies.




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