There has been a lot of talk lately about the decline in the real interest rate. This is a very important topic because the real interest rate is a key determinant of investment spending. In this blog post I will explain what the real interest rate is how it is determined and why it has been declining.
What is the real interest rate?
The real interest rate is the interest rate after inflation is taken into account. For example if the nominal interest rate is 5% and the inflation rate is 2% then the real interest rate is 3%.
How is the real interest rate determined?
The real interest rate is determined by the interplay of three forces: the demand for money the supply of money and inflation.
The demand for money is determined by people’s preferences. People demand money for two reasons: to transact and to store value. The demand for money to transact is called the transaction demand and the demand for money to store value is called the asset demand.
The supply of money is determined by the money-creation process. In a fiat money system like the one we have in the United States the money supply is determined by the actions of the central bank. The central bank can increase or decrease the money supply by buying or selling government bonds.
Inflation is determined by the interplay of the demand for money and the supply of money. If the demand for money is greater than the supply of money then prices will rise and we will see inflation.
Why has the real interest rate been declining?
There are a few reasons for this.
First the demand for money has been growing more slowly. This is due to a variety of factors including slower economic growth declining population growth and the increasing use of electronic payments.
Second the supply of money has been growing more rapidly. This is due to the actions of the central bank which has been increasing the money supply in an effort to stimulate the economy.
Third inflation has been declining. This is due to a variety of factors including slower economic growth and declining energy prices.
All of these factors have led to a decline in the real interest rate.
What does this mean for the economy?
A decline in the real interest rate is generally bad for the economy. This is because it makes it less attractive for people to save and invest. When people save less investment spending declines and this can lead to slower economic growth.
There are however some offsetting factors. One is that a lower real interest rate makes it cheaper for firms to borrow and this can lead to increased investment spending. Another is that a lower real interest rate makes it easier for households to service their debt and this can free up resources for spending.
Overall though the evidence suggests that a decline in the real interest rate is likely to be bad for the economy. This is why central banks are trying to raise the real interest rate.
References:
Dornbusch R. & Fischer S. (1980). Macroeconomics. New York: McGraw-Hill.
Mankiw N. G. (2012). Macroeconomics. New York: Worth Publishers.
What is the definition of a decline in the real interest rate?
A decline in the real interest rate is defined as a decrease in the rate of interest that is paid on loans and other investments.
What are the causes of a decline in the real interest rate?
There are a number of possible causes of a decline in the real interest rate including inflation economic growth and changes in monetary policy.
What are the effects of a decline in the real interest rate?
A decline in the real interest rate can lead to increased borrowing and investment as well as increased spending and economic growth.
How does a decline in the real interest rate affect savers?
A decline in the real interest rate can reduce the amount of interest that savers earn on their savings and may encourage them to spend more.
How does a decline in the real interest rate affect borrowers?
A decline in the real interest rate can reduce the cost of borrowing and may encourage borrowers to take out loans and invest.
What are some of the risks associated with a decline in the real interest rate?
Some of the risks associated with a decline in the real interest rate include inflation asset bubbles and financial instability.
What is the relationship between a decline in the real interest rate and inflation?
A decline in the real interest rate can cause inflation as increased borrowing and spending can lead to higher prices.
What is the relationship between a decline in the real interest rate and asset bubbles?
A decline in the real interest rate can cause asset bubbles as investors may be tempted to invest in assets such as property and stocks that may be overvalued.
What is the relationship between a decline in the real interest rate and financial stability?
A decline in the real interest rate can cause financial instability as it may lead to increased borrowing and speculation.
What are some of the possible implications of a decline in the real interest rate?
Some of the possible implications of a decline in the real interest rate include inflation asset bubbles and financial instability.
What is the significance of a decline in the real interest rate?
A decline in the real interest rate can have a number of implications including increased borrowing and investment as well as increased spending and economic growth.
What are the possible long-term effects of a decline in the real interest rate?
The possible long-term effects of a decline in the real interest rate include inflation asset bubbles and financial instability.
What are the possible short-term effects of a decline in the real interest rate?
The possible short-term effects of a decline in the real interest rate include increased borrowing and investment as well as increased spending and economic growth.
What are the risks of a decline in the real interest rate?
Some of the risks associated with a decline in the real interest rate include inflation asset bubbles and financial instability.
What should be done in the event of a decline in the real interest rate?
In the event of a decline in the real interest rate it is important to monitor the situation and be aware of the potential risks.
