Risk and Business Cycles (Foundations of the Market Economy) by Tyler Cowen

Author:Tyler Cowen [Cowen, Tyler]
Language: eng
Format: epub
Publisher: Taylor and Francis
Published: 1997-12-31T23:00:00+00:00

DO INTEREST RATES PROVIDE USEFUL INFORMATION ABOUT CONSUMER DEMAND?

The Austrian claim requires that entrepreneurs use interest rates to forecast the content of consumer demand. Following a decline in real interest rates, long-term investment rises for two distinct reasons, according to the Austrian claim. First, the lower real rate increases the relative present value of long-term projects. Second, the lower real rate provides a signal about the composition of future demands. In other words, entrepreneurs expect demand to be high for the outputs of long-term projects, and expect demand to be relatively low for the outputs of shorter-term projects.

The available evidence does not lend much credence to this second signal extraction problem. In reality, the real interest rate appears to play only a weak role in signaling how demands will be distributed across time. Expectations about income and employment provide more important information about the intertemporal variation in future demands.

The Austrian claim postulates not only that the interest-elasticity of investment decisions is high, but that the interest-elasticity is high for a particular reason. When entrepreneurs are forecasting whether demand for product A or product B will be higher, entrepreneurs supposedly examine the real interest rate to resolve the question. The real interest rate has importance above and beyond its effect on present value calculations; the real interest rate signals information about future demand curves for products in the Austrian world. To the extent the real interest rate does not signal information about demand curves, one of the two signal extraction problems behind the Austrian claim does not apply. Lower real interest rates will not induce entrepreneurs to conclude that demand for long-term outputs has risen (the second signal extraction problem).

Real interest rates do have significant predictive power for the demand for debt-financed consumer durables, such as homes and automobiles. Consumers often cannot save enough to buy houses, and must rely on mortgages. Demand curves for homes will depend on real interest rates. Mistaken expectations about future borrowing rates therefore may induce entrepreneurs to produce unprofitable outputs, such as homes, when consumers cannot afford mortgages.

The Austrian claim, however, specifies a different mechanism through which low interest rates signal high consumer demand in the future. The low real interest rate signals that savings are high today, and that consumption demand therefore will be strong in the relatively distant future. Debt-intensive purchases, as discussed above, imply the following chain of reasoning: entrepreneurs use current real interest rates to forecast future real interest rates, and use their estimates of future real interest rates to forecast future demand for debt-intensive purchases (e.g., real estate). The Austrian claim implies a different and less plausible chain of reasoning: today’s real interest rates, completely apart from any extrapolation about future real interest rates, help predict future demands by predicting forthcoming expenditure flows.

Several factors suggest that real interest rates will be poor predictors of future demand curves. The preponderance of evidence on consumption indicates great stability over time and with respect to the real interest rate (e.g., Carlino 1982; Christiano 1987a, 1987b; Campbell and Mankiw 1989).

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