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
delong@econ.berkeley.edu
http://www.j-bradford-delong.net
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.
So:
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
- The market for investment funds, in which firms demand
funds and households (through financial intermediaries) supply
them.
- The market for stocks and bonds, in which households
(through financial intermediaries) demand securities and firms
supply them.
- These are the same thing: it just depends on what you see as
the commodity being sold and what as the means of payment
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...
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