Chapter 3: System Dynamics of Interest Rate Effects on Aggregate Demand
Linwood Tauheed and L. Randall Wray Introduction ‘Perverse’ Interest Rate Effects on Aggregate Demand? Heterodox economics has always been sceptical of the Fed’s ability to ‘finetune’ the economy, in spite of the long-running Monetarist claims about the efficacy of monetary policy (even if orthodox wisdom is used to disdain discretion). The canonization of Chairman Greenspan over the past decade and a half has eliminated most orthodox squeamishness about a discretionary Fed, while currently fashionable theory based on the ‘new monetary consensus’ has pushed monetary policy front and centre. As Galbraith argues, lack of empirical support for such beliefs has not dampened enthusiasm. Like Galbraith, the followers of Keynes have always insisted that ‘Business firms borrow when they can make money and not because interest rates are low’ (Galbraith, 2004, p. 45). Even orthodox estimates of the interest rate elasticity of investment are so low that the typical rate adjustments used by the Fed cannot have much effect. Conventional belief can still point to interest rate effects on consumption, with two main channels. Consumer durables consumption, and increasingly even consumption of services and non-durables, rely on credit and, thus, might be interest-sensitive. Second, falling mortgage rates lead to refinancing, freeing disposable income for additional consumption. Ultimately, however, whether falling interest rates might stimulate consumption must depend on different marginal propensities to consume (MPCs) between creditors and debtors. In reality, many consumers are simultaneously debtors and creditors, making analysis difficult because a reduction of rates lowers both debt payments and interest income....
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