How Do Changes in Interest Rates Affect the Level of Economic Activity?

interest rates

Roy Harrod has some rather interesting opinions on the effectiveness of interest rates. As readers of this blog know I am rather skeptical of using interest rates to steer the economy. Basically this is because I think that using them on their own will only result in ever-diminishing returns. Steve Randy Waldman discussed this with reference to the work of Michal Kalecki here, but similar arguments can be found in Joan Robinson’s Introduction to the Theory of Employment from 1937.

Another problem with using interest rates to steer economic activity is that they can, as Kaldor pointed out, lead to substantial instability in expectations and thus diminish investment in productive plant and machinery. I discussed this at length here but I will quote Kaldor once more because it is instructive. In his paper Monetary Policy, Economic Stability and Growth he wrote:

If bond prices were subject to vast and rapid fluctuations [due to the central bank manipulating the interest rate to steer the economy], the speculative risks involved in long-term loans of any kind would be very much greater than they are now [i.e. in the Keynesian era], and the average price for parting with liquidity would be considerably higher. The capital market would become far more speculative, and would function far less efficiently as an instrument for allocating savings – new issues would be more difficult to launch, and long-run considerations of profitability would play a subordinate role in the allocation of funds. As Keynes said, when the capital investment of a country “becomes a by-product of the activity of a casino, the job is likely to be ill-done”.

All that aside there is still the question as to how monetary policy actually has its effects and I think that Harrod’s views deserve some consideration on this point. He runs through a few thought experiments to show that a change in the interest rate shouldn’t actually effect the real level of investment all that much. He then turns to ask if monetary policy can prove effective in increasing or decreasing the level of economic activity. He comes up with two ways in which it is effective.

The first is simply on housing construction. Harrod is entirely correct about this. Housing construction is a very large component of economic activity and the interest rate has a substantial effect on this. The same is true of auto loans. But the second reason he gives is even more interesting. Indeed, it seems to be a progenitor to the ‘credit rationing’ arguments that started to penetrate the literature in the 1980s and 1990s. But I think that it is slightly more sophisticated than the rationing theories in that it explicitly makes a point about the institutional structure of the capital markets that such theories miss. I will quote Harrod at length here from his book Money.

It must be remembered that the capital market is for most people an imperfect one. There are bits of the capital market which function in the way of perfect markets, where at any one moment there is a going price at which the individual (other than some giants, like the government broker) can satisfy his needs. Such are the gilt-edged end of the stock exchange [i.e. stocks for state-backed, nationalised industries] and the discount market. But most borrowing for capital outlay is not done in these markets. There are all the various channels for borrowing, the commercial banks themselves, the market for new issues, financial syndicates, insurance companies and, above all, trade credit, which plays a vital role. In these various markets it is not a question of just taking out as much money as one wants at the going price. It is a question of negotiation. When the aggregate money supply is reduced, a would-be borrower may find it more difficult, and even impossible, to raise money through his accustomed channels; and conversely. It is essentially the imperfection of the capital market that makes monetary policy a powerful weapon. (pp64-65)

I think that Harrod is fundamentally correct on this issue. Raising interest rates does actually mean that, for a lot of borrowers, their interest rate doesn’t simply rise. Rather they cannot access the market for funds at all. They are shut out. And Harrod is also right to point out that there are many corners of the capital market in which prices simply do not arise; lenders simply say to borrowers “no thanks!”.

This does not, however, do anything to alleviate my concerns about using monetary policy as the main tool for macroeconomic stabilisation. I still maintain that this is inherently problematic. But it does show one channel through which interest rate changes might affect the real economy.

About pilkingtonphil

Philip Pilkington is a London-based economist and member of the Political Economy Research Group (PERG) at Kingston University. You can follow him on Twitter at @pilkingtonphil.
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46 Responses to How Do Changes in Interest Rates Affect the Level of Economic Activity?

  1. Funky says:

    The natural conclusion of the credit ration literature which Stiglitz and Greenwald have drawn is that you cannot just look at the price (interest rate) but also gotta take a look at the quantity (not money aggregates but the level of loan activity).
    This is done in an informal way, everybody was aware of the freezing of credit markets at the beginning of the financial crisis. But central bank models do not contain actual variables that reflect the level of loans, at least the core model is basically just Woodfordian DSGE.

    • And that freezing, in Keynesian language, is a “liquidity trap”. You’re right about one thing: Stiglitz’s ideas are actually close to Keynes’ in some ways. Not so for that muck Krugman feeds his audience on his blog day after day.

      • Funky says:

        Stiglitz resembles Keynes in not using models in his popular writings. He is also, like Keynes, somebody who has been educated as classical economist and spent most of his work life to show its short-comings. To me most of Stiglitz work is basically a robustness test of Arrow-Debreu, he relaxes a tiny assumption about perfect information and suddenly everything collapses, the outcome is no more (even remotely) socially efficient.

        And while many folks nowadays use models with asymmetric information they are not ready to accept its radical conclusions (that the two welfare theorems don’t hold) and rather try to pacify them.

        Krugman on the other hand does use IS-LM in his popular writing but always makes it clear that this is just a tool and not a model which he literally believes in which is why criticizing him because of IS-LM is dubious, he never pretends that this model is more than a crutch. And while anybody who read Hicks after ’37 should be aware of the shortcomings of IS-LM I think that it is the best mechanism / model / tool which once can use to explain basic short-run macro to laymen (of course one should also be able to do it equally well in prose and I have actually used Krugman’s babysitting coop story when I tried to explain why recessions exist to friends).

      • Really? He doesn’t believe it? I guess you forgot about that time he said that the Iraq War deficits were going to lead to spiking interest rates and hinted at some sort of fiscal crisis! Lol!

        Krugman desperately believes in his models. Just read his stuff on comparative advantage from the 1990s to see it. The argument is always the same. (1) Lay out highly abstract model. (2) Draw real-world conclusions from the abstract model about the policy. (3) Flatter his audience into thinking that anyone who doesn’t believe in NAFTA must be intellectually deficient.

        I suppose step (4) is now to pretend like he’s not really using the models when people call him on his BS. Step (5) is tell fibs about what position he took in 2012 with regard to endogenous money, but I suppose we shouldn’t get into that rather awkward evasion.

      • Funky says:

        First of all, IS-LM is just a formalization of the most important ideas of the General Theory which are a) liquidity preferences and b) general (dis)equilibrium analysis. Keynes did it in prose, Hicks did it in maths.

        The advantage of the latter is that you can check for mistakes that can occur if you think merely in prose. The disadvantage is that you can become oblivious to the implicit assumptions you make. As I wrote above, Hicks wrote about these problems after 1937 but despite his awareness of the dynamic issues (LM is stocks, IS is flows, expectations are missing and so on) he could not create a superior model.
        I am not a die-hard advocate of economic models, the discipline has certainly gone too far. But what you seem to advocate, pre-Samuelson just prose is just the other extreme and thus not the solution either. I just read that you have just been into economics for four years so at least I understand now why you don’t like the little maths in econ and why you don’t know much about what you always criticize, classical economics.

        Second, your claim is wrong Krugman has often pointed out that IS-LM is just a simple back-of-the-envelope model which captures the essence of what is going on right now. His liquidity trap paper from 1998 was e.g. a way to check whether the liquidity trap which is easily visible in IS-LM also exists in a two-period model.As more complex models (like the financial ones by Stiglitz&Greenwald which I often mentioned because they are forgotten) boil down to IS-LM there is theoretical merit to this notion.
        If you actually viewed economics not just as an intellectual game but as a serious issue that impacts the well-being of millions you would not call the most influential public advocate of deficit spending a muck.

        Third, free trade is a good thing. But it is also just theory as the first world is cheating, we protect (mainly) our first sector via subsidies but force third world countries to open their markets. Furthermore trade deals often contain stuff that has nothing to do with free trade, e.g. the Trans-Pacific Partnership is more about giving corporations more rights than about opening up markets.

      • I think that you have some reading to do if you think that Hicks’ model is a mathematical form of Keynes’ argument in the General Theory, Mr. Keynes Expert. Try: Hicks, John (1980–1981), “IS-LM: An Explanation”, Journal of Post Keynesian Economics, v. 3: 139–155

        In the meantime read up on Krugman’s ISLM predictions from 2003.

        Oh, and its good to see that you think “free trade is a good thing”. Did you get that rather unnuanced opinion from… shock!… a MODEL by any chance!?😀

        Oh, Funky. Funky, Funky, Funky. So naive.

      • Funky says:

        if you had read my post you would know that I read the Hicks paper you linked to, he does discuss the stock-flow issues of IS-LM in it.
        If anybody has an unnuanced opinion about free trade it is not the guy who points out that what is called free trade is often just a Trojan horse for Western protectionism (food markets) or empowerment of corporations (TPP) but the guys who says “free trade is bad coz I say so!”.

      • I never said “free trade is bad”. But I also never said “free trade is good”.

        You said that free trade was good but that its not really practiced. That is a blanket statement and you picked it up from a model.

        You see, Funky. Those models that you think you don’t take seriously… they control your opinions without you even realising it. Typical mainstream puppet.

      • Funky says:

        As always you are arguing against a strawman, the nasty classical economist who is dogmatic. Ironically I am a classical economist who reads and aprpeciate some Post-Keynesian literaure whereas you are a Post-Keynesian who never read a paper with an alpha in it because you wasted your undergraduate years on critical theory or sociology or whatever.

        Now what does Econ 101 say on trade: if I wanna sell something for a minimum of 10 and you wanna buy something for the maximum of 11 and we both can trade for a price between 10 and 11 we are both better off.
        Now if the reduction of trade barriers goes hand in hand with a reduction of regulation, e.g. of food safety, it could reduce welfare. And indeed I think so because of a model. In a world of asymmetric information the regulation of some goods is necessary. if you eat food and become sick you might have a hard time determining which kind of food actually made you sick so food has to be regulated.
        But the source of the problem is not more trade but reduction of food regulation.

        About the free flow of capital (free trade usually refers to free output and not free capital markets), basic economics says that it is a good thing but there is ample of literature on the problems of “hot money”, how it can destabilize economies and so on. There is also important evidence on the problem of trade imbalances because of what is happening in Europe right now so there are good reasons for capital market regulations.

        Now I’d like to hear your thoughts on the issue. Or you can go on fighting against a strawman, the evil classical dogmatic economist, and not provide any analysis at all.

      • Thank you for proving my point: namely, that you DO in fact believe in models.

        Me? I have that terrible tendency that puts me at odds with the dogmatists. I DON’T believe in models and I think that the world is more complex than that. I think that every issue needs to be approached in its particularity and that only gullible fools buy into simplistic arguments like the one you just put forward. Sometimes trade can be good, sometimes bad. There are no absolutes in this regard.

        Here’s a link to some extensive criticisms of comparative advantage arguments. But let me preface it before you read it: you will not change your opinion on this issue. You cannot. No amount of logical argument or counter-evidence could EVER get you to change your opinion on this issue. And that is because you’re a dyed-in-the-wool mainstreamer. I could tell the moment I started engaging with you from the way you spoke. Always, like a priest.

        Anyway, I have to go to bed. But I’m glad we’ve now established that you DO, in fact, believe in your models. They’ve saturated your mind and anything that sneaks up on you from outside just causes cognitive dissonance. Sorry, but you’ve been through The Program. You’ll never get your critical faculties back now.😉

    • Funky says:

      Of course I do understand, unlike you, the merit of models. But unlike you I am not dogmatically arguing for just one method, I also understand the merit of mere prose. When you approach a new topic there is little collective knowledge about it so the guy who first thing about it have to be vague.

      You on the other hand are arguing for just one method, prose, yet at the same time call me a braindead dogmatic. Involuntary self-irony is always entertaining.

      • Funky says:

        “I could tell the moment I started engaging with you from the way you spoke.”

        Same here. I knew from the first nonsense I saw you writing on Syll’s blog about the ontological inexistence of labour markets and the long run that you spent your undergraduate years studying philosophy, then crossed over into econ, were overwhelmed by the maths (which is not really that complicated compares to other disciplines), never read and paper with a bit of maths in it a, criticized something you don’t even know* and continued to think like a philosopher instead of like an economist.

        * – Post like this (https://fixingtheeconomists.wordpress.com/2014/05/02/why-economists-fail-to-make-rational-judgments-and-why-you-should-too/) are a sublime example of your lack of understanding. Opportunity costs are just another way to express trade-offs: if I visit the theatre in the evening I cannot visit the ball game, if I work an extra hour I cannot enjoy an extra hour with my girlfriend, if I spend my income on a trouser I cannot buy a shirt with that money. This has nothing to do with values, propaganda or whatever, everybody compares these alternatives differently, nobody indoctrinates anybody to go to the theatre instead of the ball game or vice versa or how to make this choice, people do it automatically and often unconsciously.

      • Oh Funky, you’re making a fool out of yourself again. How do you know that I am against mathematical formalism in economics? You don’t. You just assumed it. If you looked into it you’d find that my main work is a formal algebraic approach to asset-pricing. It’s not complicated maths, no, but it is maths.

        See, you just make things up without evidence. You just assume your conclusions. You say “Oh, well Phil must be X, Y, Z…” when you have no evidence of this. It’s the model-oriented mindset. You think in a prioris. It’s so obvious to everyone else. But you can’t admit it to yourself. And then you bash anyone who has engaged in an ounce of self-reflection as being ‘postmodern’ or whatever other hackneyed phrase you can come up with on the spot to articulate your hatred of critical thinking and you devotion to dogmas like “Free Trade is Always and Everywhere Good So Long as Everyone Plays By the Rules”.

  2. NeilW says:

    “Raising interest rates does actually mean that, for a lot of borrowers, their interest rate doesn’t simply rise.”

    It’s not just interest rate rises, or for that matter falls. The issue is always what money is advanced and for what purpose. Everything in economics seems to boil down to what is the mechanism for saying ‘no’ to something and ‘yes’ to something else. Since that is the basis of any sort of rationing.

    The problem with the interest rate idea is that it is assumed it is the sole, or primary, determination of whether some economic activity is ever proposed, or declined if it is proposed. I’d suggest a whole raft of other issues are just as important, if not more important – particularly those ‘animal spirits’. You can fairly easily come up with a scenario where a fall in interest rates – signalling an economy in trouble – causes a sudden sharp rise in underwriting standards.

  3. “I think that Harrod is fundamentally correct on this issue. Raising interest rates does actually mean that, for a lot of borrowers, their interest rate doesn’t simply rise. Rather they cannot access the market for funds at all. They are shut out. And Harrod is also right to point out that there are many corners of the capital market in which prices simply do not arise; lenders simply say to borrowers “no thanks!”.”

    Also don’t forget that if the market is in a period of debt saturation lowering rates may not affect lending either because of low demand for debt.

    I think the focus should be on money and not its cost. Money is what is spent and how it is used is affects market returns and interest rates.

    Interest rates are moved by expanding funds by the central bank so the funds themselves are more important IMO. How funds are expanded is the result you get on growth inflation and rates. Therefore the CB should expand funds while pursuing its targets with the public which have a higher propensity to consume than current counterparties. Also the central bank could expand money without necessitating an increase in debt unlike commercial banks which usually expand money through lending.

    Imagine a system where most people had enough savings to purchase a home without borrowing? Interest rates movements would have a negligible effect on the economy.

    • Funky says:

      “Also the central bank could expand money without necessitating an increase in debt unlike commercial banks which usually expand money through lending.”

      I don’t follow you here. You advocate an increase of base money which does not increase higher money aggregates by a larger amount, i.e. which does not increase deposits / loans. This could only happen if the expansion of base money went hand in hand with an increasing preference for cash instead of deposits (happens e.g. during a bank run) or if banks don’t lend out the extra money because loan demand is low or because they have to fix their balance sheets (both happen right now).

      Money works through two channels, inflation (expectations) which impacts real wages and real interest rates and loans. What you want seems to be the closure of the second channel, perhaps via full-reserve banking. At least this is how I read this:

      “Imagine a system where most people had enough savings to purchase a home without borrowing?”

      The problem is not monetary policy but lack of expansionary fiscal policy. it is just Keynes, Fisher and Koo, we are in a liquidity trap (partially because of historically bad monetary policy), it is hard to get out of it as inflation is low and low inflation / deflation plus too much public debt leads to a long period of deleveraging. In this rare situation monetary policy cannot do its job anymore, easy and cheap credit is pointless without loan demand so fiscal policy has to create demand. Not to mention that in a world with too much saving, too little investment, the need to repair broken public infrastructure and educations system and the even more dire need to switch our energy production towards regenerative energy source you don’t have to be a supply-side socialist to advocate massive public investment.

      • “I don’t follow you here. You advocate an increase of base money which does not increase higher money aggregates by a larger amount, i.e. which does not increase deposits / loans. This could only happen if the expansion of base money went hand in hand with an increasing preference for cash instead of deposits (happens e.g. during a bank run) or if banks don’t lend out the extra money because loan demand is low or because they have to fix their balance sheets (both happen right now).”

        If the central bank allowed people to hold base money electronically (aka reserves) like it does with commercial banks then these funds are exactly like commercial bank deposits in terms of functionality. Therefore the base and the overall money supply can increase even if commercial bank deposits don’t increase.

        “Money works through two channels, inflation (expectations) which impacts real wages and real interest rates and loans. What you want seems to be the closure of the second channel, perhaps via full-reserve banking. ”

        Im not advocating full reserves. Heres a brief rundown: cmamonetary.org
        Expanding the base will continue to bring down the interest rate under my proposal. Supply and demand.

        The problem is both monetary and fiscal policy. Fiscal policy should be facilitating investment in the sciences like you say but monetary policy also lift the economy and cease to be overly debt centered.

  4. Benedict@Large says:

    The point of using monetary policy to control the macroeconomy is to take that control away from the electorate. Capitalism abhors democracy.

    • Funky says:

      Nope. Historically speaking many CBs have been founded to be a lender of last resort. It took the ECB years to remember this and their bad memory led to immense unemployment and suffering.
      What you propagate is anarchist nonsense, macro-stabilization is absolutely necessary.

      Now whether CBs are well-controlled democratic institutions or serving too often the interest of rentiers is a different issue. But to proclaim that “to control the macroeconomy” is undemocratic just ignores economic history.

      • philippe101 says:

        “CBs have been founded to be a lender of last resort”

        The ECB is specifically prohibited from lending to national governments. But it can lend freely to commercial banks.

        It would appear that Benedict is correct, at least in the case of the ECB.

  5. philippe101 says:

    Philip,

    Sorry to bother you with more austrian stuff, but what do you think about this:

    http://consultingbyrpm.com/blog/2014/05/the-final-nail-in-the-coffin-mpk-is-not-sufficient-for-interest-either.html

    (also, see my comments [Philippe] in the comment section)

    Here is Bob’s follow up:

    http://consultingbyrpm.com/blog/2014/05/a-note-on-the-real-rate-of-interest.html

    • Oh Phillipe, you know how I love Austrian economics!😀

      Unfortunately, Bob Murphy and other so-called Austrian capital theorists do not seem to do Austrian economics. Rather they appear to do a variant of New Classical economics as is evidenced by the following:

      Suppose our hypothetical economy only last for 10 periods, and that everybody has perfect foresight of what’s coming

      The unfortunate thing that Keynes and the Post-Keynesians have to tell people like Bob (who don’t listen, but then they don’t want to listen so that’s not surprising) is that there is no such thing as a natural rate of interest once Keynesian/Knightian uncertainty and expectations are introduced into the capital markets. In this case, the money rate of interest will never converge with full employment equilibrium because expectations will push it toward inflation/deflation without any intervention by the central bank.

      The Austrians claim that they do dynamic theory incorporating Knightian uncertainty. But what they really mean is: they do dynamic theory incorporating Knightian uncertainty when it suits their ideological agenda. When it does not, they revert to a crude variant of New Classical economics. Feel free to point this out to Bob. You can quote me if you’d like. But it’s all there in Keynes, so he should know this stuff already.

      • philippe101 says:

        I agree that “everybody has perfect foresight” is a ridiculous assumption. But it’s just a make-believe model. What I’m interested in is whether the model says what Bob thinks it says. He argues that in this model, the real return on capital is zero. I think that’s incorrect, as it seems to me that the real return comes from ‘deflation’, i.e. the value of the birds increasing over time. What do you think?

      • I find it very hard to make out what he is trying to say. I don’t think that he’s communicating what he is trying to get across very well. It strikes me as a muddle.

        If you are correct that the number of birds decrease in every period. And if there is a constant population and a constant distribution of income then the real wage rate and the real profit rate should decline over time.

        Again, I can’t make out whether the number of birds decrease in every period. Nor can I make out whether there is a constant population. It strikes me as a muddle.

    • Funky says:

      I know that you hate “marginalism” … but I just gotta say that the marginal benefit of reading Austrian economists is zero or negative.

    • philippe101 says:

      sorry, I meant the real rate of return on capital.

    • philippe101 says:

      “I can’t make out whether the number of birds decrease in every period. Nor can I make out whether there is a constant population.”

      the number of birds that can be caught in each period decreases over time. The population is constant, and demand for birds is constant.

      • Then you should have a declining real wage and real profit rate. That’s not a deflation or an inflation. Just a decline in real income (bird GDP, I guess).

      • philippe101 says:

        so, in period 1 it might take you one hour to catch a bird. In period 10, there a far fewer birds flying around so it will take you a lot longer on average to catch one, and the total amount of birds that can be caught at that time is less than in period 1.

      • philippe101 says:

        “Just a decline in real income”

        Doesn’t that mean that each unit of real income is gaining in value?

      • Decline in income then. That’s all.

        How this ties into Piketty’s empirical work, I have no idea. But that’s Austrianism!

      • Doesn’t that mean that each unit of real income is gaining in value?

        Denominated in terms of what?

      • philippe101 says:

        “Denominated in terms of what?”

        time, or labor?

      • As I said: the real wage declines. But prices don’t rise or fall. There are no prices. Just birds.

      • philippe101 says:

        assume everyone has to eat a certain number of birds in each period.

        if the supply of birds decreases over time, then their value in real terms has to go up, doesn’t it?

        If everyone has to eat one potato every day to stay alive, and over time the supply of potatoes dries up, then that will increase the value of potatoes.

      • Not if the potato/bird is the numeraire. Something cannot increase in value relative to itself.

        However, you do raise a point about the incompleteness of Bob’s model: if he doesn’t set a subsistence wage rate, then we cannot say if the economy can reproduce or not.

      • philippe101 says:

        I mean, for example, that when potatoes/birds are plentiful, you might be willing to give up, say, 1 hour of your time to acquire one. But when they are extremely scarce, you might be willing to give up years of your labor, your house, your car, etc, just to get one.

      • philippe101 says:

        “if he doesn’t set a subsistence wage rate, then we cannot say if the economy can reproduce or not.”

        He implicitly assumes that demand for birds is constant. So we can say that if the supply decreases over time, then people will be willing to give more for each bird over time.

      • I don’t think Bob’s model had a utility function either. If it did you could alter it in line with a decreasing marginal disutility of labour for every bird wage-unit as the birds dried up.

        I suppose what you’re saying is that you want to take the wage-unit as the numeraire. But since this is not a money wage-unit this is problematic.

        But if you added money into the equation then you would definitely get inflation on the supply side.

      • philippe101 says:

        “you would definitely get inflation on the supply side”

        don’t you mean deflation?

      • If each worker is paid, say, $10 to catch birds and there are 10 workers and they catch 10 birds each then, if all the money is spent on birds, each bird will be $1.

        If you make the same assumption but reduce their haul to 5 birds each then each bird will cost $2. Hence: inflation.

        Put more formally: aggregate supply contracts while aggregate demand (in money terms) remains constant. Hence: price increases.

      • philippe101 says:

        ok, rising price of the good in question, so inflation.

      • If you introduce money and assume constant money wages and a constant propensity to consume then yes. How could it be otherwise?

      • philippe101 says:

        deflation and inflation are really different sides of the same coin.

        If dollars buy less goods, that means goods buy more dollars, and vice versa.

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