Tuesday, May 17, 2016

Cameron Murray — The mysterious real interest rate of economic theory

The mysterious real interest rate - the one typically denoted as r in economic theory - does not have a real life counterpart. This is a problem for economic theory. And it is a major problem for policy makers relying on monetary policy to boost economic activity.

While we think of the nominal interest rate minus inflation as getting close to the theoretical concept of real interest rates, changing this value in practice through central bank operations does not actually change the real return on capital and stimulate investment through that channel.
Why?

Because the price of capital is determined by the interest rate! We have known this for a long time. Joan Robinson wrote about the circularity of reasoning when we measure the quantity of capital by its price. She was ignored. As I expect to be.…
Fresh economic thinking

3 comments:

Matt Franko said...

"loose monetary policy may primarily inflate asset prices, and not economic activity. This prediction gels with the reality of the past decade."

This is what Buffett was saying the other day wrt to ZIRP... if govt went ZIRP as a permanent policy Buffet says DowJones goes directly to 100,000...

If they start raising then fiscal will become more supportive..

The other thing is the guy here has to just give up on the concept of "inflation"...

Tom Hickey said...

This is what Buffett was saying the other day wrt to ZIRP... if govt went ZIRP as a permanent policy Buffet says DowJones goes directly to 100,000...

Only if government doesn't use its regulatory power, like setting margin requirements. Set ZIRP AND zero leverage on equities, and corresponding leverage on other assets that banks loan against. They leverage with be left to the shadow banking system and the risk would be enormous since there would be zero government backing. Imprudent firms would go bankrupt. Knowing this investors and lenders would be on notice.

BTW, this is real capitalism, not the phony "capitalism" we have now where firms don't go bankrupt, only "the little people do." The risk is supped to be on lenders to firms and investors in firms. Instead the risk has been shifted onto workers that have gone to consume.

Tom Hickey said...

Correction" "the risk has been shifted onto workers that have gone INTO DEBT to consume"

But I left out mortgage exposure, too. I meant that to be covered in bank regulation with a prohibition against lending based on increasing land rents. Up the required ante to 30% down and no borrowing for the down.