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I'm not sure you can toss out the marginal product of capital concept. It seems integral to what he is saying.

The question is, if the marginal product of capital equals the real interest rate, what should the real interest rate be today?

Corporate profits to gdp are at peak levels. This is the average product, but it must give some clue as to the marginal one.

"One of the key points that Market Monetarists (Scott Sumner especially) keep making (and that keeps getting ignored) is that low (nominal and real) interest rates are not a sign that monetary policy is loose, but are a consequence of monetary policy being tight."

How is a central bank deciding to lend at a low interest rate the consequence of anything other than the central bank deciding to lend at a low interest rate? You might blame high bond prices as an artifact of tight monetary policy or a number of other things. I think Scott keeps forgetting that monetary policy (at least in the U. S.) consists of two policy levers - the interest rate a central bank will lend at and the price that the central bank (via open market operations) will pay for existing bonds.

Chris House says “In the traditional IS/LM model, investment demand is assumed to depend negatively on the real interest rate. This assumption is important for the functioning of the model…”.

There is a slight problem there. Two recent studies indicate that there is little relationship between interest rates and investment. See:




Or as J.K.Galbraith put it, “firms borrow when they can make money and not because interest rates are low”: a point which is intuitively obvious to those running business, but apparently not obvious to economists.

anon1: I'm not tossing out the MPK concept. But it won't (in general) be equal to the rate of interest (even ignoring depreciation). It will equal the real rental rate on capital, assuming perfect competition, and that firms can sell as much output as they wish. But the real rental rate is not the same as the real rate of interest.

Suppose, for example, that output prices are fixed, and that nominal wages W and rental rates on capital R are perfectly flexible, and that both labour and capital goods are in perfectly inelastic supply (in the short run). A fall in AD and Y would cause both W and R to fall to zero, and firm's profits would increase to equal the whole of Y.

Ralph: Suppose that demand for investment depends (positively) on demand for output Yd, and negatively on r. If the effect of Yd on I is strong enough, you get an upward-sloping IS curve, and shocks to the LM curve will show a positive correlation between I and r.

A fall in Y that causes R and W to fall to zero would also imply that Y is at zero, no?

So you're saying corporate profits to gdp are at peak because demand for capital goods is depressed? Corporate profits to gdp were at trough during the Great Depression.

Also, is the "short run" for capital goods supply five years?

I'm not sure I understand how the fact of (peak profits and booming asset prices) gets reflected in NK thinking. For instance, in the concept of the natural rate, or depressed AD, etc. It seems these are all predicated on some kind of a continuing "recession" that is nowhere in evidence in most asset prices or profit measures.

@Ralph: "firms borrow when they can make money and not because interest rates are low”

But an important question for determining whether one can make money is "What rate can I borrow at?" In looking at potential investments at the trading firm I worked at, we were always comparing the predicted return to our borrowing cost in deciding whether or not to invest. Naturally, with a lower cost of borrowing, more investments looked good than with a higher cost.

Last year I ran a whole series of Granger causality tests on Mishkin’s elementary nine channel Monetary Transmission Mechanism:


And a lot of the results ran counter to New Keynesian wisdom, but would not at all be surprising to Market Monetarists. My sample period was 1993Q1 through 2013Q2.

With respect to the Traditional Real Interest Rate Channel, I find that the real (adjusted by the year on year PCEPI) 10-year T-Note yield Granger causes private nonresidential investment (PNFI) and private residential investment (PRFI) but I found no correlation with durable goods spending. More importantly, the impulse response is *positive* in each case. In other words *higher* real interest rates lead to higher investment spending.

In addition to bringing up Tobin's Dynamic Aggregative Model (with its upward sloping IS curve):


Chris House also mentions Tobin's q:


Tobin's q theory provides a mechanism through which monetary policy affects the economy through its effects on the prices of equities. Tobin defines q as the market value of firms divided by the replacement cost of capital. If q is high the market price of firms is high relative to the replacement cost of capital, and new plant and equipment is cheap relative to the market value of business firms. Companies can then issue equity and get a high price for it relative to the cost of the plant and equipment they are buying. Thus investment spending will rise because firms can buy a lot of new investment goods with only a small issue of equity. On the other hand when q is low, firms will not purchase new investment goods because the market value of firms is low relative to the cost of capital. If companies want to acquire capital when q is low, they can buy another firm cheaply and acquire old capital instead. Investment spending will be low.

In 1993 (back when Larry Summers was still doing research) Blanchard, Rhee and Summers found that "fundamentals" (i.e. profits) predict investment much better than Tobin's q:


Here is Tobin q and investment for the nonfinancial corporate sector since 1993Q1:


The correlation is significant at the 1% level with Tobin's q explaining over 56.9% of the variation in investment. Note that Tobin q appears to lead investment as well. Thus it should not be at all surprising that Tobin q Granger causes private nonresidential investment (PNFI) and that the impulse response is positive.

In contrast, as had been noted in the econblogosphere several months ago, after tax corporate profits no longer have a positive correlation with investment. Here is profits after tax and investment for the nonfinancial corporate sector:


Interestingly the correlation since 1993 is also significant at the 1% level but it is negative.

In other words, in the last 20 years Tobin q has done a much better job than corporate profits in explaining investment.

I suspect were the Blanchard, Rhee and Summers study were repeated with high frequency data for 1993-2013 (they did it for annual data from 1900-1988) the conclusions would be very different.

"low (nominal and real) interest rates are not a sign that monetary policy is loose, but are a consequence of monetary policy being tight"

Or low rates can be a sign that monetary policy is innefective. If the transmision mechanism worked more efficiently then rates and growth would be higher.

anon1: "A fall in Y that causes R and W to fall to zero would also imply that Y is at zero, no?"

No. Assume you own a firm. You rent the services of labour and the services of capital (machines) to produce output. You earn revenue from selling that output. You use some of that revenue to pay wages on labour and rentals on capital, and what is left over is your profit.

Now assume you own that capital equipment, and rent it from yourself. When we talk of "profits", we would now include the rentals on capital. But does it make any difference. Not really.

Nick, Thanks for the mention but you are too modest. I learned from Friedman that easy money can cause higher interest rates, but it wasn't until I read your blog that I realized the implication that the IS curve will often slope upwards.

BTW, I agree with your final sentence. I've watched the markets closely for decades, and still have trouble finding stable relationships in this area.

Scott: thanks. But that was me interpreting you. "What Scott is saying (though he doesn't use these words) is that the IS curve slopes up."


I was wondering if I might ask you a question I was curious about. I asked this of Chris House in the comments of his recent post regarding IS-LM (but he didn't answer it):

This is unfortunately not an area of economics I know well, but it seems like a change in the marginal product of capital reflects in a shifting of the demand curve for investment, not in the direction of the demand curve for investment. As a businessperson, whatever the MPC is, and all other things equal, I always want to invest more with a lower interest rate than I do with a higher interest rate. As MPC increases, the interest rate will increase, but not because the demand curve for investment depends positively on the interest rate, but because it depends negatively on the interest rate, but shifts out with increases in MPC. Again, not an area I know well, but this is how it seems. I mean is the IS-LM model for a given MPC, just as a classic supply and demand model for apples is for a given marginal productivity in apple farming – change that MP, and you just change one of the curves; it doesn’t invalidate the model

At: http://orderstatistic.wordpress.com/2014/02/16/a-faustian-bargain/comment-page-1/#comment-391

It also reminds me of the recent low interest rates causing low inflation, cargo-cult brouhaha. Chris doesn't say this, but it seems to move towards the idea that high interest rates cause high business investment, when the phenomena is that the causation comes from a third factor: Higher MPC causes both higher business investment and higher interest rates.

Richard: Put K on the horizontal axis, MPK on the vertical axis, hold other things like L and technology constant, and you get a downward-sloping MPK curve. And (in a simple one-good model) that gives you a negative relation between the rate of interest and the desired stock of K. Now suppose there's a change in technology, that increase MPK for any given level of K. The whole MPK curve shifts up. And if actual K and L are fixed, that change in technology increases r.

The ISLM model holds technology constant as you move down along the investment demand curve, but it does not hold L constant. Plus, there's the stock-flow distinction between K and I.

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