The Equilibrium Real Rate of Interest

Three basic factors—supply, demand, and government actions—determine the real interest rate. The nominal interest rate, which is the rate we actually observe, is the real rate plus the expected rate of inflation. So a fourth factor affecting the interest rate is the expected rate of inflation.

Although there are many different interest rates economywide (as many as there are types of securities), economists frequently talk as if there were a single representative rate. We can use this abstraction to gain some insights into determining the real rate of interest if we consider the supply and demand curves for funds.

Figure 5.1 shows a downward-sloping demand curve and an upward-sloping supply curve. On the horizontal axis, we measure the quantity of funds, and on the vertical axis, we measure the real rate of interest.

The supply curve slopes up from left to right because the higher the real interest rate, the greater the supply of household savings. The assumption is that at higher real interest rates households will choose to postpone some current consumption and set aside or invest more of their disposable income for future use.1

The demand curve slopes down from left to right because the lower the real interest rate, the more businesses will want to invest in physical capital. Assuming that businesses rank projects by the expected real return on invested capital, firms will undertake more projects the lower the real interest rate on the funds needed to finance those projects.

Equilibrium is at the point of intersection of the supply and demand curves, point E in Figure 5.1.

1 There is considerable disagreement among experts on the issue of whether household saving does go up in response to an increase in the real interest rate.

134 PART I Introduction

Figure 5.1 Determination of the equilibrium real rate of interest.

Figure 5.1 Determination of the equilibrium real rate of interest.

The government and the central bank (Federal Reserve) can shift these supply and demand curves either to the right or to the left through fiscal and monetary policies. For example, consider an increase in the government's budget deficit. This increases the government's borrowing demand and shifts the demand curve to the right, which causes the equilibrium real interest rate to rise to point E\ That is, a forecast that indicates higher than previously expected government borrowing increases expected future interest rates. The Fed can offset such a rise through an expansionary monetary policy, which will shift the supply curve to the right.

Thus, although the fundamental determinants of the real interest rate are the propensity of households to save and the expected productivity (or we could say profitability) of investment in physical capital, the real rate can be affected as well by government fiscal and monetary policies.

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