How Do Changes in Interest Rates Affect the Level of Economic Activity?

by Philip Pilkington

Roy Harrod has some rather interesting opinions on the effectiveness of interest rates. As readers of this blog know I am rather skeptical of using interest rates to steer the economy. Basically this is because I think that using them on their own will only result in ever-diminishing returns. Steve Randy Waldman discussed this with reference to the work of Michal Kalecki here, but similar arguments can be found in Joan Robinson’s Introduction to the Theory of Employment from 1937.

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Another problem with using interest rates to steer economic activity is that they can, as Kaldor pointed out, lead to substantial instability in expectations and thus diminish investment in productive plant and machinery. I discussed this at length here but I will quote Kaldor once more because it is instructive. In his paper Monetary Policy, Economic Stability and Growth he wrote:

If bond prices were subject to vast and rapid fluctuations [due to the central bank manipulating the interest rate to steer the economy], the speculative risks involved in long-term loans of any kind would be very much greater than they are now [i.e. in the Keynesian era], and the average price for parting with liquidity would be considerably higher. The capital market would become far more speculative, and would function far less efficiently as an instrument for allocating savings – new issues would be more difficult to launch, and long-run considerations of profitability would play a subordinate role in the allocation of funds. As Keynes said, when the capital investment of a country “becomes a by-product of the activity of a casino, the job is likely to be ill-done”.

All that aside there is still the question as to how monetary policy actually has its effects and I think that Harrod’s views deserve some consideration on this point. He runs through a few thought experiments to show that a change in the interest rate shouldn’t actually effect the real level of investment all that much. He then turns to ask if monetary policy can prove effective in increasing or decreasing the level of economic activity. He comes up with two ways in which it is effective.

The first is simply on housing construction. Harrod is entirely correct about this. Housing construction is a very large component of economic activity and the interest rate has a substantial effect on this. The same is true of auto loans. But the second reason he gives is even more interesting. Indeed, it seems to be a progenitor to the ‘credit rationing’ arguments that started to penetrate the literature in the 1980s and 1990s. But I think that it is slightly more sophisticated than the rationing theories in that it explicitly makes a point about the institutional structure of the capital markets that such theories miss. I will quote Harrod at length here from his book Money.

It must be remembered that the capital market is for most people an imperfect one. There are bits of the capital market which function in the way of perfect markets, where at any one moment there is a going price at which the individual (other than some giants, like the government broker) can satisfy his needs. Such are the gilt-edged end of the stock exchange [i.e. stocks for state-backed, nationalised industries] and the discount market. But most borrowing for capital outlay is not done in these markets. There are all the various channels for borrowing, the commercial banks themselves, the market for new issues, financial syndicates, insurance companies and, above all, trade credit, which plays a vital role. In these various markets it is not a question of just taking out as much money as one wants at the going price. It is a question of negotiation. When the aggregate money supply is reduced, a would-be borrower may find it more difficult, and even impossible, to raise money through his accustomed channels; and conversely. It is essentially the imperfection of the capital market that makes monetary policy a powerful weapon. (pp64-65)

I think that Harrod is fundamentally correct on this issue. Raising interest rates does actually mean that, for a lot of borrowers, their interest rate doesn’t simply rise. Rather they cannot access the market for funds at all. They are shut out. And Harrod is also right to point out that there are many corners of the capital market in which prices simply do not arise; lenders simply say to borrowers “no thanks!”.

This does not, however, do anything to alleviate my concerns about using monetary policy as the main tool for macroeconomic stabilisation. I still maintain that this is inherently problematic. But it does show one channel through which interest rate changes might affect the real economy.