Econ 100b

Created 4/30/1996
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Lecture Seven

Short Run and Long Run Equilibrium
(Economics 100b; Spring 1996)

Professor of Economics J. Bradford DeLong
601 Evans, University of California at Berkeley
Berkeley, CA 94720
(510) 643-4027 phone (510) 642-6615 fax

February 2, 1996

The Federal Reserve Took Action on Wednesday, January 31
Equilibrium and the Interest Rate
Loanable Funds
Fiscal Policy and National Savings
Shifts in Investment Demand--Identification

The Federal Reserve Took Action on Wednesday, January 31

Federal Funds rate down from 5.50% to 5.25%; so-called discount rate down from 5.25% to 5.00%.

Federal Reserve hopes to boost investment somewhat...
A small move, yet the San Francisco Chronicle thought it was the most important thing to happen on January 31...
Federal Reserve action based on information about the state of the economy two months ago; will have the most effect on investment 12-18 months from now...
The impossibility of "fine tuning"...
Long and variable lags.

Equilibrium and the Interest Rate

We began this week by taking a look at the supply of goods and services--at the production function, the economy's technological capabilities for turning factors of production into useful commodities. We then moved on to discuss aggregate demand for goods and services.

How can we be certain that all these flows balance? What ensures that the sum of consumption, investment, and government purchases equals the amount of output produced.

In this model the interest rate--which, as you remember, is shorthand for an enormous and complex spectrum of different interest rates and financial asset prices--has the crucial role of adjusting to match aggregate supply with aggregate demand.

In reality as well as in the model, the interest rate is the thing that can shift to match aggregate supply with aggregate demand--but it doesn't always do so. And in more complicated models we will start to see why.

Greg Mankiw goes through an algebraic exercise to prove that the interest rate must adjust: he starts with the national income identity:

Y = C + I + G

Government chooses T and G; aggregate supply and full employment fix Y; once we know Y and T, we know G. The only thing that is left to ensure that both sides of the identity balance is I, and I(r). So r must adjust.

Loanable Funds

I think a better--or more intuitive--way to think about it is to focus on financial market equilibrium. Think back to the circular flow diagram: all household income was, in a sense, being spent--on taxes, on consumption, or dropped into the bank or into a mutual fund through savings. (What about people who try to hoard cash and bury it under their pillows? Remember that they have to get the cash from someone--and if they hoard, someone else is dishoarding.)

Now what about total expenditure? Well, there is no gap between consumers' spending out of their income and consumption expenditures. But there is a potential gap between what the government spends and what it taxes--the government's deficit--and also a potential gap between what households and businesses save and what businesses wish to invest.


Now what makes private saving equal to the deficit plus investment?

We know that investment is a decreasing function of the interest rate--the higher the interest rate, the lower is investment.

What if in some year it should turn out that, at prevailing interest rates, that the government deficit plus private investment amounted to much more than private savings?

A government deficit means that the government is selling bonds. Every couple of weeks Darcy Bradbury announces that the U.S. Treasury is holding an auction: issuing a lot of bonds for cash. Private business investment (in excess of retained earnings and depreciation allowances) requires firms to raise cash as well: to issue bonds, to issue stock, to find banks with excess deposits that wish to make more loans.

If the government deficit plus private investment is greater than savings, then a lot of bonds are going to be hitting the market this quarter--but there is little increase in investors' and financiers' ability to purchase them. Sure, you could sell something else to raise the cash to buy newly-issued securities, but that is just an asset transfer: someone else in the financial markets has parted with that cash. The only net new source of funds for investors and financiers to use to buy Treasury bonds and other securities is--you guessed it--the inflow of private savings.

Hence if deficit plus investment is greater than private savings, a bunch of bonds will go unbought--prices of existing bonds and of newly issued bonds will fall, as the price of any commodity in excess supply will fall.

And a fall in the price of bonds and stocks is a rise in the interest rate.

What? You may say. Think about it. Suppose I own a bond--let's take the limiting case, a British consol, which is a bond with no maturity date.

Concept of maturity date...

Well a consol doesn't have one...

British government will pay you interest forever.

Consol sells for 100; pays an annual coupon of 6. That's a nice 6% interest rate.

Suppose its price falls to 75; and I sell it to someone at that price. What interest rate are they getting for their investment? 8%.

Suppose a business--that could have borrowed money at 6% by selling 6-coupon bonds for 100--finds that now, because consols are only selling for 75, its bonds are only selling for 75? All of a sudden it is paying an 8% interest rate too.

It is going to think twice about investment projects at this new, higher interest rates.

If the interest rate is too low, than businesses want to invest more than the economy is willing to save; inventories of bonds will build up; prices of bonds will fall; interest rates rise; and businesses will think twice about investing and shrink their investment plans.

Conversely, if the interest rate is too high, there will be excess demand for bonds...

And so the interest rate will start to fall...

We have equilibrium--and full employment, and financial markets with neither excess supply nor excess demand--where the interest rate is such that savings equals investment, and the supply of loans and bonds equals the demand. And there are powerful forces in financial markets working to push r to the equilibrium level.

Fiscal Policy and National Savings

Now let's think about shifts in fiscal policy. Say, suppose the government cuts taxes and doesn't do anything else.

The federal deficit is bigger...

All of a sudden Darcy Bradbury is selling more bonds...

Excess supply of new bonds and loans...

Their prices drop--interest rates rise.

As interest rates rise, firms cut back on investment plans, and equilibrium is restored, with interest rates higher, investment lower, consumption higher...

Why is consumption higher? <Yeah, I know you're probably asleep, but why?><Marty>

So the shift in fiscal policy has transferred some of GDP from investment to consumption uses.

Federal budget went from a small (inflation-adjusted) surplus in the 1970s to an average deficit of 3 percent of GDP in the 1980s; real interest rates on short-term government bonds went from 0.4% to 5.7% in the 1980s. Gross national saving fell--Mankiw says from 16.7% in the 1970s to 14.1% in the 1980s.

Don't talk about Clinton program here

Increases in government spending? Shift GDP from investment to government.

Shifts in Investment Demand--Identification

The way we have set things up, a boom in investment demand has no impact on actual investment. Why? Because aggregate savings are invariant to the interest rate. When households decide how much to consume and how much to save, they don't look at the interest rate. Thus net demand for new loans and bonds is pretty stable; an increase in loan and bond supply--because of a boom in investment demand--in a commodity with fixed supply lowers the price, and raises the interest rate.

I've probably lost you there. I've noticed that for the past two weeks I've been switching back in forth between

Hence if you want to boost the volume of investment, and thus the rate of capital deepening, and thus the rate at which America's economy grows, probably shouldn't be in the business of providing savings incentives (tax breaks, etc.).

Modified consumption-savings function. Does higher reward induce more savings? Theological dispute--although I, being on one side of it, see the evidence as crystal clear. Intertemporal income and substitution effects.

Be nice to Greg and to Michael Boskin.

In the real world interest rates and investment move together, not inversely. We do not see much movement along a constant I(r) curve. Shocks to investment demand appear to dominate...


Econ 100b

Created 4/30/1996
Go to
Brad De Long's Home Page

Professor of Economics J. Bradford DeLong, 601 Evans
University of California at Berkeley
Berkeley, CA 94720-3880
(510) 643-4027 phone (510) 642-6615 fax