Question

What forces determine the level of interest rates? Be familiar with the National Saving/ Investment framework we used to model the determination of interest rates. What is crowding-out? What factors increase or decrease savings? What factors increase or decrease investment. Understand the arguments for and against Ricardian equivalence. Use the savings model we have developed to compare the effect on Demand and the real interest rate of deficit-financed tax cuts and government spending increases.

Answer 1

Interest rate levels are mainly determined by three forces -

1. Federal Reserve: It determines the short term interest rates.
2. Treasury Investors:Interest rate on long term loans such as consumer loans for automobiles,education and large consumer purchases such as furniture.
3. Banking Industry:The highest level of interest rate is the credit card rate because they require a lot of maintenence since they are a part of revolving credit.

Crowding out effect is the damping effect on initial increase in spending due to the increased interest rates and the increase in public sector spending which leads to the reduction in private investment. When the interest rate gets high enough, only the government is able to afford the cost of borrowing and thus private firms are “crowded out” of the market.

Factors that increase or decrease savings:

• Age of individuals affect the savings as people from 30-50 age group tend to save more for retirement whereas after retirement people run savings down.
• Higher interest rates attract people to increase their saving.
• Higher inflation leads to decrease in saving.
• Increase in income is another factor which increases saving.

Investment is financed mainly through savings or borrowing .When the interest rate is high it is difficult to borrow thus decreasing the investment.It also makes the firm think twice before investing in future projects if it has already started a project.The demand is the main factor which enables the firm to invest in a country if the economic growth is poor the demand will fall which again decrease the investment.Improvement in technology can influence the attractiveness of investment.