Something Wicksell this way comes
If the government fixes the price of petrol, apartments or avocadoes, it will learn soon enough if it got the price wrong: too low, shortages appear; too high, gluts materialize. In the market for credit, it’s a tougher call. The central bank in the short run fixes the price of credit via the interest rate, but has no ready way of knowing it got it right. With a fiat currency, an increased demand for credit automatically brings forth more supply, and a decrease in the demand reduces the supply.
Yet out there, somewhere, is a "correct" interest rate, sometimes called the natural interest rate, or Wicksellian rate. This week’s Free Exchange column explains:
Over a century ago Knut Wicksell, a Swedish economist, drew the distinction between the financial rate of interest that borrowers actually pay and the natural rate of interest that was determined by the return on capital. If the financial rate is below the natural rate, businesses can reap unlimited profits by borrowing as much as they can and ploughing it into high-returning projects. Eventually, though, all that additional spending pushes up prices, money and credit, and eventually, financial interest rates.
The natural interest rate is often assumed to be constant. … But, according to Wicksell, the natural rate is “never high or low in itself, but only in relation to the profit which people can make with the money in their hands, and this, of course, varies. In good times, when trade is brisk, the rate of profit is high, and, what is of great consequence, is generally expected to remain high; in periods of depression it is low, and expected to remain low.”Central banks pay implicit homage to Wicksell. Their models, for instance in this paper by Thomas Laubach and John Williams, assume the existence of an equilibrium real rate of interest that keeps the economy operating at potential. Keep the actual rate below the equilibrium rate, and the economy speeds up, eventually generating inflation. Keep it above, and it slows down, eventually tipping into recession. But unlike Wicksell, the Fed does not invoke the difference between the financial rate and the return on capital to explain how monetary policy works. Indeed, the empirical link between capital spending and interest rates is not very strong. Rather, the primary channels by which monetary policy works are household durable consumption, housing, and financial variables such as the exchange rate and the stock market.
At root, though, Wicksell’s original formulation is still relevant. Households may not think of themselves as having some target return on capital, but they still have preferences for consuming now versus consuming in the future. Atering interest rates, by bending those preferences, can stimulate or dampen aggregate demand today. Make the real interest rate negative enough, and the increased pleasure that comes from consuming today vs saving and consuming tomorrow becomes overwhelming. This, ultimately, is why the IS curve in the IS-LM model slopes down.
As Greg Mankiw and John Campbell noted back in 1989, it’s hard to find a strong, empirical connection between movements in real interest rates and movements in consumption. After crunching the numbers, they found that consumption responded far more to expected income. This doesn’t mean there’s no role for the interest rate; it could be that, to influence consumption, the interest rate must offset opposite pressure from changes in expected income. In other words, when consumers expect to be much wealthier in the future, they are more willing to borrow against that wealth. To prevent an inflationary surge in consumption, the central bank tightens. When households expect to be less wealthy, they don't want to borrow until the central bank lowers interest rates enough.
That seems to be what ails America now. The University of Michigan each month asks households how much they expect their income to grow in the coming year, and as the nearby chart shows, those expectations have collapsed. Since the start of 2009, the median household has expected its income to grow just 0.4% in the next 12 months, i.e. decline in real terms....MORE
