Investment and Interest Rates: Two Perspectives

Paul Krugman responds to the following criticism:

One argument I’ve been hearing a lot lately runs as follows: “Low interest rates got us into this mess, so it’s crazy to think that low interest rates are the solution.” [link]

Although he thinks Greenspan ignored subprime lending and signs of the looming housing crisis, he does think Greenspan did the right thing. In fact, Krugman thinks cutting the rates even further is the way to go:

What we have now is a spending slump. It’s the consequence of easy credit that led to reckless spending in the past — but the problem now is how to sustain spending; trying to encourage austerity at this point will just make things even worse. Keep cutting, Ben!

However, what I found interesting was the counter-intuitive notion that cutting rates would actually decrease investment. In a recently published paper by UC Berkeley’s Raj Chetty, he explains:

To see the intuition, consider a pharmaceutical company deciding how quickly to proceed with investments in operations to produce new drugs. The firm is uncertain about drugs that will be successful and can acquire further information via R&D by delaying investment. The cost of delaying investment is that the firm cannot retire its outstanding debt as quickly, raising its interest expenses. Now consider how an increase in the interest rate will affect the firm’s behaviour. A higher interest rate reduces the set of drugs that surpass the hurdle rate for investment, creating the standard cost of capital effect that acts to reduce the scale of investment. But a higher interest rate also makes the firm more eager to retire its debt quickly by investing immediately and earning profits sooner. This second “timing effect” acts to raise current investment. I show that these two opposing forces combine to generate a non-monotonic investment demand curve that is upward sloping at low interest rates.

What he is saying is that a pharma firm that is delayed in its investment by the necessity for more R&D, would actually increase its investment to earn its profits sooner, even though interest rates have increased. This creates a postive relationship between investment and interest rates.

Of course, this is a highly specific situation, and I am unaware of any macro-level empirical study that shows this counter-intuitive relationship exists. But I thought it was interesting, nonetheless.

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