## A “weird” case for a higher interest rate

Is there a case for raising interest rates by the Fed? Even a weird one?

In the previous post, I explained the reasoning behind the current lower level of real GDP. The explanation is that real GDP declines to an equilibrium with the low interest rate in the money market for labor income.

So if a lower interest rate lowers equilibrium real GDP, then would a rise in the interest rate raise real GDP?

First I want to show a graph posted by Nick Rowe back in August of 2011. In his post, he explains In his post, Mr. Rowe explains the “weird” up-sloping IS curve as he puts it. Yet, even though it is weird, I agree with the graph. The graph basically points to “where we are” and “where we want to be”, and then draws a line between those points.

“Where we want to be” is a natural rate of interest that is positive. I have written before that the natural rate of interest is positive, but many economists say that the natural rate of interest is negative.

Mr. Rowe gives 2 definitions of the natural rate of interesting the comments section of the post where the graph comes from.

“1. What would equilibrate desired saving and investment given the actual level of income and actual expectations for future income.

2. What would equilibrate desired saving and investment if income were at the natural rate (LRAS) and were expected to remain so.

You are using it in sense 1; I am using it in sense 2.”

I agree with Mr. Rowe that #2 is the better definition to use. When real income (real GDP) reaches its natural rate at the LRAS curve (effective demand limit), there is a natural rate of interest that will keep real GDP stable.

So how does he explain the up-sloping IS curve?

“3. Why does my IS curve slope up? It is not because I think that a higher interest rate would increase demand for newly-produced goods. Rather, it is because I think that a sustained increase in demand for goods would have such a strong self-reinforcing effect on desired investment and consumption that interest rates would need to rise to keep output demanded equal to output. The marginal propensity to invest plus the marginal propensity to consume exceeds one, in other words. Take a normal Old Keynesian IS curve, and assume mpc+mpi>1, and it will slope up.  I explain this more in an earlier post.”

He is describing a mechanism by which a sustained increase in demand for goods would be accompanied by not only a rise in desired investment, but also a rise in interest rates. The result would be that output demanded would equal output.

I don’t want to get into the LM curve in this post, but my view is that the LM curve is flat now. But when the natural rate of real income is reached, it may continue horizontal or go vertical or anywhere in between depending on what the central bank decides. Mr. Rowe says as much for the vertical LM curve.

As Mr. Rowe says…

“The LM curve does not have a fixed slope. The slope of the LM curve is whatever the central bank wants to make it.”

The LM curve comes from the equilibrium states in the model for the money market. Yet, I want to show now that the what Mr. Rowe sees in the goods market of the IS curve, I see in the money market of the LM curve.

In the previous post, I divided the money market into two markets, one for labor income and one for capital income. These two markets behave differently, so we need to understand the money market for labor income because it is a powerful force to determine the purchasing power for goods.

Here is a video using this model of the money market for labor income to show how an increase in interest rates would coax a rise in real GDP a la Nick Rowe’s “weird” IS curve. (previous video that set up this model.)

Just as Mr. Rowe’s up-sloping IS curve was weird, the idea that business will invest more at a higher interest rate is weird. Yet the money market shows that possibility. The idea is that the money market searches for its equilibrium. And if money supply and the interest rate are held constant, the only way to find that equilibrium is by a shifting demand curve.

Also, Mr. Rowe saw in the IS curve that a higher demand for goods would result in a higher demand for investment. He also saw that the interest rate would respond by rising. And I show that in the money market for labor income, a higher interest rate would coax demand for goods to a higher equilibrium, which would create a self-enforcing effect on desired investment.

The demand curve in the money market can shift from a rise in prices or a rise in real GDP. The bet is that with a carefully increasing interest rate, real GDP would rise more than prices.

So according to these weird points of view, a higher interest rate would correspond to a higher real GDP and higher investment… bringing an end to the depressed economy.

I would like to include a video that was on a related post by Nick Rowe. The video shows that to create an equilibrium in an inverted pendulum, the first reaction is to move in the opposite direction that the disturbance is going. The purpose of the video I think is to get us to think in wild and weird ways to bring the economy back into a healthy equilibrium.