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"Low (real and nominal) interest rates are not a sign of easy monetary policy; they are a consequence of (expected) tight monetary policy."

Or, you could think of it this way: higher interest rates mean that spending is substituted from the present to the future and vice versa. In this way, defining loose monetary policy as high spending relative to the future, low interest rates are always expansionary - even if they are consistent with recessions that last for a long time. It has everything to do with expectations. If interest rates (real and nominal) are expected to return to normal at some point, then lower interest rates represent loose money in an absolute sense; current nominal spending is higher and nominal spending growth is expected to return to normal in the long run. If, as is probably the case in Japan, interest rates are expected to be permanently lower than they were in the late 80s, then expectations of future nominal spending growth have fallen. This is, of course, rational in the case of Japan because of the demographic decline (perhaps combined with low inflation expectations, at least between 1997 and 2012). I guess, at least in a New Keynesian framework, we should be thinking about the expected path of interest rates to understand the expected path of nominal spending and the current interest rate to see where nominal spending is relative to future nominal spending.

John: if you were talking about a consumption-only economy, I think what you say would be right. If we are in recession today, so output is lower than normal, and is expected to rise, then the (real) interest rate must be above the long-run natural rate.

But when we add investment to the model, it isn't right. Because the fact that the economy falls into a recession means that the desired capital stock (for a given real interest rate) is less then the actual capital stock. Because the shadow rental rate on capital goods falls when the economy enters a recession. So the real interest rate would need to fall to offset that negative effect on investment demand.


As long as the economy converges to a balanced growth path, it shouldn't matter very much. Lets say there is an economy with a representative agent who maximizes the utility function U = B^t(u(c_t)) where 0 < B < 1 is the discount factor and u(c_t) = 1/(1-a)c_t^(1-a) subject to the budget constraint (1 + r_t-1)k_t-1 + y = c_t + k_t where k_t is the capital stock that will be carried over into the next period, r_t is the next-of-depreciation real interest rate, and y is the constant endowment that the representative agent is given each period. The first order condition for consumption is c_t^-a = B c_t+1^-a (1 + r). Assuming this economy converges to a balanced growth path in which every variable grows at g, the real interest rate will be r = r* + ag where r* = 1/B - 1 is the time preference rate. Low interest rates are always consistent with lower long run growth and vice versa. In the short run, the 'cyclicality' (pretty sure this isn't really a word, but it sounds cool) of the real interest rate should depend on the kind of shock.

John: what you are describing there is a Robinson Crusoe model. What I am describing is a symmetric Prisoners' Dilemma model. Robinson Crusoe never wishes he would buy more of his own goods. My agents in a recession wish that they would all buy more of each other's goods, but it is not individually rational for them to do so.

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