Which Interest Rate Seems Most Related to Business Investment? A Few Preliminary Findings from an Ongoing Study

This paper examines (econometrically) which interest rates seem most systematically related to investment and the GDP and how long the lag time is before changes in these interest rates affect the GDP. We conclude that the Prime interest rate has the most important and systematic influence on these variables and that it affects investment and the GDP after a two year lag due to the lengthy periods required to design, bid and build new factories, commercial facilities and some machinery. Other rates examined, but not found related to investment - triggered GDP growth, include the Aaa and Baa corporate bond rates, the Mortgage interest rate and the 10 year Treasury bond rate. Our results also suggest the magnitude of the effect of interest rate changes on the economy is relatively modest, and that therefore the Federal Reserve's ability to influence the economy by changing rates may also be somewhat constrained.

Which Interest Rate Should We Use In The Is Curve?

Do interest rates effect investment and the GDP? If so, which ones, and by how much? Research on this topic over 5 decades has produced conflicting results. Yet, this question is of critical importance to the viability of Keynesian macroeconomics. This paper attempts to explain why results have been conflicting. It also attempts to determine with some finality which rate(s), if any, are related to GDP through the standard Keynesian mechanism: the IS curve. The paper tests exhaustively (1) a variety of real and nominal rates, (2) different hypotheses about how businesses calculate “real” interest rates (3) how the number of lags used affects results, (4) whether small sample size inherent in annual time series data adversely affects results, and (5) whether lack of hetroskedasticity and autocorrelation controls in earlier studies influenced their findings. This paper concludes only the real prime or Federal funds rates, lagged two years and the nominal current mortgage rate are significantly related to variation in the GDP, and running the prime rate alone picks up most of the variation in both. The prime rate was found to be twice as important as the mortgage rate. It also finds relatively small size (40 observation) annual data sets do not lead to problems achieving statistical significance, at least in simple IS curve models. It also finds that post - 1980 White and Newey - West correction methods for hetroskedasticity make it far more likely that any of a wide variety of interest rates and lags will be found statistically significant than was the case in earlier studies, but that correcting for multicollinearity between rates again leaves only the real prime and Federal funds rate lagged two periods and perhaps the current nominal mortgage rate significant. The effect of changes in the prime rate and mortgage rates on the GDP, though systematic, appears to be small, implying the IS curve may be nearly vertical and the Fed’s interest rate policy of little significance unless rate changes are draconian. We estimate that even a five percentage - point change in the real Federal funds and prime rates changes GDP only 2.4%, and employment only 1.2% maximally (using Okun’s law). Other findings were that nominal interest rates deflated by adaptive expectations models of inflation using the past two year’s inflation seem to best describe how businesses calculate real rates. Rational expectations models were least successful. Other rates examined include the ten year treasury rate, the Aaa and Baa corporate rates. They were seldom found statistically significant, but the mortgage rate’s estimated marginal effect seems to also capture these rates’ effect on the economy.

Does A Strong Dollar Increase Demand For Both Domestic And Imported Goods?

Rising exchange rates strengthen the dollar and lower prices on imported consumer goods. Lower import prices have two effects. (1) A substitution effect that shifts demand from domestically produced goods to imports. (2) An income effect that increases demand for imports even further. However, it also allows some income previously spent on imports, but no longer needed due to lower import prices, to be shifted to purchases of domestic goods. This paper finds that for the U.S., 1960 - 2000, the income effect overwhelmed the substitution effect. As a result, econometric results suggest declining import prices increased both import demand and demand for domestically produced consumer goods. The estimated increase in demand for domestically produced consumer goods and services was 3.4 times as large as the increase in demand for consumer imports. Also, because of the large increase in GDP resulting from growth in domestic demand, the trade deficit grew slower than domestic output of consumer goods. This finding suggests that while the trade deficit grows as a result of a strengthening dollar, the increase, as a percent of U.S. GDP, is small, about four tenths of a percent for a ten percent strengthening of the dollar.

Does Consumer Confidence, As Measured By U. Of Michigan Indices, Affect Demand For Consumer And Investment Goods (Or Just Proxy For Things That Do)?

Declining consumer confidence is cited as a cause of declining consumer demand, independent of changes income, wealth, etc. If so, it may also affect demand for investment goods, as businesses adjust production to reflect changes in consumer confidence and its anticipated effect on demand. This paper examines the University of Michigan’s Index of Consumer Sentiment (ICS), and the Index of Consumer Expectations (ICE), a subcomponent of ICS also used in the Index of Leading Economic Indicators Index. Using simple two variable regressions ICS lagged one year explained considerable variance in current consumption (but not vice versa). Both the ICS and ICE lagged one year were found systematically related to consumer demand for nondurable goods, but not durable goods, services, or total consumer demand when an extensive list of other factors affecting demand such as income, wealth, interest rates, credit availability and the exchange rate were controlled for. Neither ICS nor ICE was found related to any component of investment.

Do Falling Import Prices Increase Market Demand for Domestically Produced Consumer Goods?

Rising exchange rates can lower prices on imported consumer goods. The lower prices have two effects. A substitution effect shifts in demand from domestically produced goods to imports. An income effect also allows more import purchases. It also allows some income previously spent on imports to be shifted to domestic spending. This shift may or may not increase total demand for U.S. consumer goods. This paper finds it does, and that increases in demand for domestically produced consumer goods and services are about five times as large as the increase in demand for imported consumer goods and services. The paper also finds that the increase in demand for domestic goods is about three times as large as the increase in the trade deficit resulting from the higher exchange rate.

Do Tax Cut And Spending Deficits Have Different Crowd Out Effects?

The crowd out effects of government deficits are tested by adding deficit variables to consumption and investment models which extensively control for other factors. Separate variables are added for deficits resulting from tax cuts and spending increases. Effects are calculated for recession and non-recession periods, and compared to models with average crowd out effects for the whole business cycle, and models without crowd out. Test results indicate 1) deficits crowd out private consumption and investment, are statistically significant, and explain substantial variance. They predict “IS” curve coefficients better than no crowd out models. In both recessions and non-recessions, government spending deficits were associated with complete crowd out, leaving no observable net stimulus effect. Tax cut deficits resulted in more than complete crowd out, resulting in net negative economic effects. Both findings are consistent with crowd out theory. Crowd out was found to have roughly equal effects in recessions and non-recession periods. Results are corroborated by independent testing of borrowing data; total declines in private spending were about equal to total declines in borrowing associated with deficits. Financing deficits by monetary expansion may avoid some crowd out problems, but only if the expansion is in the savings components of M2, and occurs in years immediately before the deficit is incurred, limiting its practicality. Foreign borrowing, to supplement domestic savings, can reduce the potential for crowd out.

How Falling Exchange Rates 2000-2007 Have Affected the U.S. Economy and Trade Deficit (Evaluated Using the Federal Reserve's G-10 Exchange Rate)

Falling exchange rates reduce the purchasing power of the dollar, increasing import prices. Higher import prices have two effects. (1) A substitution effect that shifts demand from imported to domestically produced goods. (2) An income effect that reduces the total amount of real income available for spending on domestic goods and foreign goods. Based on U.S. 1960 - 2000 data, this paper estimates an econometric model that finds that the income effects of falling exchange rates overwhelms the substitution effects, causing a net negative influence on the GDP and income. Results indicate demand for both imported and domestic consumer and investment goods is adversely affected because the income effect is so dominant.. For investment goods, there was virtually no substitution effect out of imported goods when import prices rose due to a falling exchange rate. Declining real income also caused decreased demand for domestically produced investment goods. For consumer goods, the substitution effect stimulated domestic demand, but was more than offset by the negative effect of declining income. The decrease in demand for domestic goods and services was 3.6 times as large as the decrease in demand for imports. Therefore, the trade deficit fell far less in dollars than the GDP. The study estimates that, other things equal, the trade deficit would fall from 4.3% to 2.1% of the GDP as a result of a large twenty percent weakening of the dollar, such as occurred 2000-07. Had the exchange rate not fallen during this period, we estimate the average annual growth rate of the U.S. economy would have been 3.7%, not the 2.7% it has actually averaged, assuming sufficient capital and labor availability to do so. Finally, we find that a falling trade deficit induced by falling exchange rates, reduces the size of the annual transfer of U.S. assets to foreigners needed to finance the deficit, but does not result in a faster rate of net growth for U.S. assets, because declining income also reduces domestic savings by a comparable amount.

How Falling Exchange Rates 2000-2007 Have Affected the U.S. Economy and Trade Deficit (Evaluated Using the Federal Reserve's Nominal Broad Exchange Rate)

Falling exchange rates reduce the purchasing power of the dollar, increasing import prices. Higher import prices have two effects. (1) A substitution effect that shifts demand from imported to domestically produced goods. (2) An income effect that reduces the total amount of real income available for spending on domestic goods and foreign goods. Based on U.S. 1960 - 2000 data, this paper estimates an econometric model that finds that the income effects of falling exchange rates overwhelms the substitution effects, causing a net negative influence on the GDP and income. Results indicate demand for both imported and domestic consumer and investment goods is adversely affected because the income effect is so dominant.. For investment goods, there was a 2.52 billion substitution effect out of imported goods when import prices rose due to a one point drop in the nominal Broad exchange rate. Declining real income also caused decreased demand for domestically produced investment goods. For consumer goods, the substitution effect stimulated domestic demand, but was more than offset by the negative effect of declining income. The decrease in demand for domestic goods and services was 2.0 times as large as the decrease in demand for imports. Therefore, the trade deficit fell less in dollars ($198B) than the GDP ($321B) in real dollars. The study estimates that, other things equal, the trade deficit would fall from 4.3% to 2.3% of the GDP as a result of a large 16.1 percent drop in the nominal Broad exchange rate index, such as occurred 2000-07. Had the exchange rate not fallen during this period, we estimate the average annual growth rate of the U.S. economy would have been 3.2%, not the 2.7% it has actually averaged, assuming sufficient capital and labor availability to do so. Finally, we find that a falling trade deficit induced by falling exchange rates ($12.31B per point drop in the rate), reduces the size of the annual transfer of U.S. assets to foreigners needed to finance the deficit by the same amount, but does not result in an equally large change upward by the end of the period in U.S. ownership of assets, because about 2/3 of this gain is offset by an income – decline related drop in savings ($8.28B per point decline in the index) during the same period.

Does the Exchange Rate Really Affect Consumer Spending?

This paper examines the extent to which changes in imports or exports of U.S. consumer goods and services occurs in response to a change in the exchange rate, 1960 -2000. The data used are taken from the Economic Report of the President, 2002. The findings indicate that an increase in the trade weighted exchange rate of about one percent is associated with an increase in imports of consumer goods of approximately $1 billion dollars the year after the change. The same level increase seems associated with a decline in con-sumer goods exports of about$0.75 billion dollars.

Determinants Of Demand For Different Types Of Investment Goods

This paper compares the demand for the three individual components of aggregate investment demand: (1) demand by businesses for plant and equipment, (2) business inventory investment and (3) residential housing construction. The models tested are largely based on Keynesian theories of business investment demand, with some allowance for residential housing demand being more driven by Keynes’ consumer demand variables. Other possible determinants of investment are also tested, including ”crowd out” effects of government deficits on business investment and demographic effects on the residential construction market. Annual data for the U.S., 1960 – 2000, are tested using two stage least squares regression techniques modified to eliminate heteroskedasticity in the data. The models are estimated in “first differences”, rather than levels of the data to reduce the effects of multicollinearity, non stationarity and autocorrelation. The models explain about 90% of the variance in plant and equipment demand, 85% of the variance in residential housing demand for and 67% of inventory demand. The results indicate that demand for each of these three types of investment goods is driven by different combinations of variables Business investment in plant and equipment appears determined by how much the overall economy is growing (the accelerator effect), the availability of credit (crowd out), the availability of depreciation reserves, the prime interest rate lagged three years, business profits and stock values lagged one year, and the effects of an exchange rate change over the four year period following the change. Inventory investment seems mainly determined by availability of depreciation reserves, crowd out, interest rates, unexpected changes in consumer demand and the accelerator. Residential construction demand seems mainly driven by disposable income, the effect of general growth in the economy on consumer spending (the accelerator), credit availability (crowd out), current year mortgage rates, and prior year consumer wealth levels.