Equilibrium Interest Rate (r*) Flashcards
What is the relationship between r and r*?
- If r>r*, this will have a contractionary effect where Y will fall below Ȳ, and Inflation falls below expected inflation
- If r<r*, this will have an expansionary effect where Y will rise above Ȳ, and Inflation rises above expected inflation
What is the Equilibrium Interest Rate (definition) ?
- r* is a theoretical point that keeps the economy at potential output without any inflationary or deflationary pressures
- This differs from r, which is the actual rate set by the bank
How does one estimate r* (State the Econometric Model)?
- Due to its difficulty to measure and observe, we use an econometric model
- Laubach-Williams Model
Name the theories of low r*
- Global Savings Glut
- Decline in Potential Output
What is the Global Savings Glut?
- Bernanke
- Significant increase in the global supply of loanable funds due to ageing population
- Savings > Investment
- Excess savings reduce IR
What is the Decline in Potential Output? What is the impact on Demand for Loanable funds and IR?
- Fall in potential output will reduce investment
- This reduces the demand for loanable funds
- Pushing down IR and reduces productivity and incomes
Explain how nominal interest rates have been declining
- There has been a reduction in Expected Inflation
- Via the Fisher Equation, if expected inflation falls, Nominal IR falls and r* falls
Explain how quantitative easing can reduce r
- By manipulating the money supply, the Government buys bonds
- This increases cash flows and the supply of money- hence reduces the interest rate
How do you solve r* being too low?
- Increase Government Spending
- This would increase the budget deficit
- In turn, there is a fall in Government savings and ‘crowds out’ the private sector
- Hence, there is a fall in supply of loanable funds and r* increases
What is the issue with increasing Government Spending (refer to r*)
- Government debt is quite high
- Debt:GDP = 97.6%
- ‘Explosive Debt’ Situation; interest burden or servicing cost
What does Kaplan say about the Neutral Rate of Interest?
- SR, r* can be influenced by non-monetary factors (changes in fiscal balance)
- LR, r* impacted by growth expectations, global supply trends and productivity
- Tough to estimate r*
- Moderation with economic policy is needed for sustained long-term growth
- Low IR from low Growth in G7 countries; from poor productivity and ageing pop.
- Increased global demand for safe assets increased price of US Treasury Bonds (low yield)
- Bond yield fell by 60 pp. in 20 yrs
- As r* is only theoretical, this is a limited thing- hence this should be used together
What statistics do the New York Fed give for r* value in 2023 Q4 using the Holstein-Laubach-Williams system?
- US: 0.73%
- Euro Zone: 0.26%
- Canada: 1.37%
Explain the formula that the Bank of England give for calculating r*
- r* = R* + s*
- R* is the trend real rate, influenced by structural matters and affects the demand for capital and wealth stock
- s* is short-term headwinds that cause small fluctuations in GDP growth- i.e. Bank runs
What happens to the nominal interest rate when r* rises?
- If r* rises, this means that there will be an expansionary effect
- Hence, as a counteractive measure, i would increase to ensure that overstimulation doesn’t happen
