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Why are real interest rates so low? Secular stagnation and the relative price of investment goods

Author

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  • Gregory Thwaites

    (Centre for Macroeconomics (CFM))

Abstract
Over the past four decades, real interest rates have risen then fallen across the industrialised world. Over the same period, nominal investment rates are down, while house prices and household debt are up. I explain these four trends with a fifth - the widespread fall in the relative price of investment goods. I present a simple closed-economy OLG model in which households finance retirement in part by selling claims on the corporate sector (capital goods) accumulated over their working lives. As capital goods prices fall, the interest rate must fall to reflect capital losses. And in the long run, a given quantity of saving buys more capital goods. This has ambiguous effects on interest rates in the long run: if the production function is inelastic, in line with most estimates in the literature, interest rates stay low even after relative prices have stopped falling. Lower interest rates reduce the user cost of housing, raising house prices and, given that housing is bought early in life, increasing household debt. I extend the model to allow for a heterogeneous bequest motive, and show that wealth inequality rises but consumption inequality falls. I test the model on cross-country data and find support for its assumptions and predictions. The analysis in this paper shows recent debates on macroeconomic imbalances and household and government indebtedness in a new light. In particular, low real interest rates may be the new normal. The debt of the young provides an alternative outlet for the retirement savings of the old; preventing the accumulation of debt, for example through macroprudential policy, leads to a bigger fall in interest rates.

Suggested Citation

  • Gregory Thwaites, 2014. "Why are real interest rates so low? Secular stagnation and the relative price of investment goods," Discussion Papers 1428, Centre for Macroeconomics (CFM).
    • Handle: RePEc:cfm:wpaper:1428
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    More about this item

    JEL classification:

    • E13 - Macroeconomics and Monetary Economics - - General Aggregative Models - - - Neoclassical
    • E22 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Investment; Capital; Intangible Capital; Capacity
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E60 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - General

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