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

Working papers set out research in progress by our staff, with the aim of encouraging comments and debate.
Published on 06 November 2015

Working Paper No. 564
By Gregory Thwaites

Over the past four decades, real interest rates have risen then fallen across the industrialised world. Over the same period, nominal investment rates fell, while house prices and household debt ratios rose. 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 accumulated over their working lives. With lower capital goods prices, a given quantity of saving buys more capital goods, but the increase in the real capital-output ratio lowers the marginal product. This has ambiguous effects on interest rates in the long run: if capital and labour are complements, in line with most estimates in the literature, interest rates remain low even if the relative price of capital stabilises. Lower interest rates reduce the user cost of housing, raise house prices and, given that housing is bought early in life, increase household debt. Housing is another vehicle for retirement saving, so omitting housing from the model exacerbates the fall in interest rates. I extend the model to allow for bequests and a heterogeneous bequest motive, and show that wealth inequality rises but consumption inequality falls when capital goods prices fall. Adding a third factor of production can reconcile the recent fall in the investment rate with the fall in the labour share. 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.

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