# 9.6: Interest Rates, Exchange Rates, and Aggregate Demand

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Bond prices, interest rates, and exchange rates determined in money and financial markets play a key role in our study of aggregate demand and output. Interest rates and exchange rates link changes in money and financial markets to the expenditure decisions that determine aggregate demand.

The impact of financial markets, interest rates, and exchange rates on aggregate expenditure, aggregate demand, and real output is described by the **transmission mechanism**. It has three important channels, namely:

- the effect of interest rate changes on consumption expenditure;
- the effect of interest rate changes on investment expenditure; and
- the effect of interest rate changes on foreign exchange rates and net exports.

**Transmission mechanism**: links money, interest rates, and exchange rates through financial markets to output and employment and prices.

## Interest rates and consumption expenditure

The basic consumption function in Chapter 6 was illustrated by a straight line relating aggregate consumption to disposable income. The positive slope of that line, the marginal propensity to consume, showed the change in consumption expenditure that would result from a change in disposable income. The vertical intercept of the consumption function showed *autonomous consumption* expenditure, the consumption expenditure *not* determined by disposable income. Changes in income moved households *along* the consumption function. Changes in autonomous consumption expenditure changed the vertical intercept, shifting the consumption function up or down.

Changes in interest rates affect autonomous consumption expenditure in two ways.

- Through a wealth effect from changes in the prices of financial assets; and
- Through a cost of credit effect.

**Wealth effect**: the change in expenditure caused by a change in real wealth.

**Cost of credit**: the cost of financing expenditures by borrowing at market interest rates.

As a result falling interest rates raise financial asset prices and rising interest rates reduce financial asset prices. This means that changes in interest rates change the wealth held in household portfolios. A fall in market interest rates raises household financial wealth which increases household consumption expenditure. Autonomous consumption expenditure increases. A rise in interest rates would reduce autonomous consumption expenditure.

Changes in interest rates also have important effects on house prices by changing the **cost of credit**, changing the present values of rental incomes, and changing the market prices of residential real estate. Households may use the market values and equity in their housing to set up home equity lines of credit. This borrowing is used to finance other expenditures. Autonomous consumption expenditures change as interest rate changes change the cost and extent of this financing.

Recently, the Canadian Minster of Finance has expressed concern about the level of household indebtedness caused by these borrowing practices. Similar borrowing against home equity magnified the effect of the 2008 financial crisis in the US and the subsequent impacts of falling house prices on consumption expenditure.

Thus, two forces—wealth effects, and availability and cost of credit—explain the effects of money on planned consumption expenditure. This is one part of the *transmission mechanism* through which money and interest rates affect expenditure. Operating through wealth effects and the supply and cost of credit, changes in money supply and interest rates shift the consumption function. We can recognize the effects of both income and interest rates on consumption by using an equation, namely:

\[C = (Y,i)\]

with a positive marginal propensity to consume out of national income, 0 < (∆*C*/∆*Y*) < 1, and a negative relationship between consumption and interest rates, ∆*C*/∆*i* < 0.

When consumption expenditure is plotted relative to national income as in the 45° line diagrams of Chapters 6 and 7, a change in the interest rate *shifts the consumption function* but does not change its slope. But it is a change autonomous consumption expenditure that will have an change AE and, working through the multiplier, change AD, output, and employment.

## Interest rates and investment expenditure

In Chapters 4 and 6 we defined investment expenditure as the purchase of currently produced fixed capital, which includes plants, machinery and equipment; and inventories of raw materials, components, and finished goods. Spending on new residential and non-residential construction is also included in investment. We assume investment is independent of current income and therefore an autonomous component of aggregate expenditure. However, the interest rates determined in money and financial markets affect investment expenditure.

The data in Chapters 4 and 6 showed investment at about 20 percent of GDP in 2013 but with the *level* of investment spending changing from year to year within a range of +/− 20 percent. Although the total change in inventories is quite small, this component of total investment is volatile and contributes to the fluctuations in the total level of investment. Interest rate changes are responsible for some part of the volatility in investment spending.

Government capital expenditures on buildings, roads, bridges, and machinery and equipment are a part of government expenditure *G*. We treat government capital expenditure as part of fiscal policy and included in *G* not in *I*.

Businesses spend on fixed capital, plant and equipment to expand their output capacity if they expect growth in demand for their output, or if the see opportunities to reduce costs by adopting new technology and production techniques. Wireless companies like Bell Canada, Rogers and TELUS spend continuously on new equipment to accommodate subscriber growth and new products that require more and faster data and voice transmission. Auto makers add to or reduce assembly capacity and develop new product and production technologies to remain competitive and to meet needs for increased fuel efficiency. Solar, wind energy and biofuel companies build new solar farms, wind farms and ethanol plants to provide new sources of electricity and fuels.

The firm’s decision to invest is based on its *expectation* of future markets and profits that will justify the estimated cost of new plant and equipment. Financial markets provide some important guidance.

The current market values of existing firms are the present values of their expected profits. A firm thinking about entering and industry or expanding its current capacity can compare the cost of building new plant and buying equipment with the market value of capital already in the industry. The investment looks profitable if the cost to enter the industry or build and install new capacity is lower than the value the market places on existing businesses. Alternatively, if the value the market places a lower value on existing business than the capital cost of new business there is no incentive to invest in more plant and equipment. However, there might be an opportunity to enter the industry by taking over an existing business.

The present value of expected profits depends on the interest rate. Changes in interest rates change both the values the market puts on existing businesses and productive capacity and the costs of financing new investment. A rise in interest rates lowers the market value of existing firms and increases the costs of financing new investment. A fall in interest rates increases current market values and lowers financing costs. As a result, investment expenditures are inversely related to interest rates, if all other conditions are constant.

Inventory management is another important part of investment expenditure. Some firms hold inventories of basic inputs to production like raw materials and may also hold components and finished product. Other firms organize their production and coordinate with suppliers to minimize inventories to achieve ‘just in time’ delivery of inputs. Financial services firms often hold inventories of bonds and other assets to help customers adjust their portfolios.

Inventories can accommodate differences in the timing of production and sales for the benefit of both producers and consumers. If demand for output rises sharply, plant capacity cannot be changed overnight. If demand exceeds current output, sellers would rather not disappoint potential customers. Car dealers hold inventories in part to help smooth the flow of production, and in part to be able to offer immediate delivery. Retail stores carry inventories so customers can buy what they want when they want it. As demand fluctuates, it can be more efficient to allow inventories of finished goods to fluctuate than to try to adjust production to volatile market conditions.

But inventories involve costs. To the producer, unsold goods represent costs of labour, materials, and energy paid but not yet recovered from the sale of the product. These costs have to be financed, either by borrowing or tying up internal funds. Retailers have similar carrying costs for their inventories. Thus, interest rates determine the important finance costs of holding inventories. If we assume prices are constant and interest rates rise, producers and retailers will want smaller inventories. Alternatively, if prices are rising, the difference between the nominal interest rate and the rate of inflation is the real cost of carrying inventories.

The **investment function** is based on these explanations of expenditure on fixed capital and inventories. The negative effect of interest rates in the investment function, (∆*I*/∆*i*) < 0, shows that higher interest rates cause lower levels of planned investment expenditure. But how sensitive are investment plans to financing costs? If these financing costs were not a large factor in the investment decision, ∆*I*/∆*i* would be small. A rise in the interest rate from *i*_{0} to *i*_{1} would still lower planned investment, but by only a small amount. Alternatively, a larger value for ∆*I*/∆*i* would mean that investment plans are sensitive to interest rates.

\[I = I(i)\]

**Investment function**, *I* = *I*(*i*): explains the level of planned investment expenditure at each interest rate.

When plotted in a diagram, the slope of the investment function *I* = *I*(*i*) is −(∆*i*/∆*I*). The *position* of the investment function reflects the effect of all factors, other than interest rates, that affect investment decisions. The price of new capital equipment, optimism or pessimism about future markets and market growth, the introduction of new technologies embodied in newly available equipment, and many other factors underlie investment decisions. Changes in any of these conditions would *shift the I function* and change planned investment at every interest rate. Increased business confidence and expectations of stronger and larger markets shift the I curve to the right. Pessimism shifts it to the left.

The volatility of investment that causes business cycle fluctuations in output and national income comes from volatility in business profit expectations, rather than from interest rates. Changes in investment, a result of changes in interest rates or as a result of other factors, shift aggregate expenditure and work through the multiplier to change AD, output, and employment. The reaction of investment expenditure to changes in interest rates provides the important link in the monetary transmission mechanism but does not explain the volatility of investment expenditure we saw in Chapter 6.

*Both nominal and real interest rates play important roles in the economy. The nominal (or money) interest rate is the annual percentage of the principal of a loan that the borrower pays to the lender. It is determined by supply and demand conditions in money markets. The real interest rate is the nominal interest rate adjusted for annual changes in the price level (real interest rate = nominal interest rate minus the inflation rate). When the inflation rate is zero, nominal and real interest rates are equal. *

*Nominal interest rates and financial asset prices are linked. The present value calculation of asset prices uses the nominal rate for discounting. Nominal interest rates and asset prices vary inversely. *

*Nominal interest rates also affect nominal cash flows of both households and businesses. A rise in nominal rates on lines of credit or mortgages increases the current cash cost of that borrowing. A fall in nominal rates on lines of credit or mortgages releases current cash commitments. *

*Real interest rates determine the real cost of borrowing and the real return to lending. *

*A family borrows $200,000 for one year at a nominal interest rate of 5 percent to buy a house. At the end of the year they would owe the lender $200,000 plus $10,000 *\(($200,000 \times 0.05)\)* interest. Their nominal interest cost is $10,000. If the price level has been constant over the year, their nominal interest cost and their real interest cost are equal at 5 percent. *

*Suppose however that the all prices are rising by 3 percent a year. The house bought today for $200,000 will sell for $206,000 one year from now. Borrowing at 5 percent to buy the house cost $10,000 but the rise in the price of the house by $6,000 offsets part of that cost. The real interest cost is *\($10,000 − $6,000 = $4,000\)*. The real interest rate is 2 percent based on the nominal interest rate of 5 percent minus the change in the price level of 3 percent. *

*With inflation rates greater than zero, lenders' real interest earnings are less than nominal interest earnings. In the preceding example, the mortgage lender's real return was just 2 percent (5 percent − 3 percent inflation) because the $210,000 received at the end of the year had its purchasing power reduced to approximately $204,000 by the 3 percent rise in the price level.*

**Application Box 9.2: Nominal and real interest rates**

## Exchange rates and net exports

The changes in foreign exchange rates caused by changes in interest rates affect the competitiveness and profitability of imports and exports relative to domestically produced goods and services. A rise in interest rates leads to an appreciation of the domestic currency. Import prices fall relative to the prices of domestic goods and services. Exports become less competitive and less profitable. Imports rise and exports fall, lowering the net export component of aggregate expenditure and demand. Alternatively, a fall in interest rates leads to a depreciation of the domestic currency. Prices of imported goods and services rise relative to the prices of domestic goods and services. Exports are more competitive and more profitable. Net exports increase.

In Chapter 6 we assumed exports were autonomous, independent of national income but dependent on foreign incomes, foreign prices relative to domestic prices, and the exchange rate, which we held constant. Imports were a function of national income, based on a marginal propensity to import, with an autonomous component to capture relative price and exchange rate conditions. Exchange rates were assumed to be constant.

Dropping the assumption that the exchange rate is constant makes the important third link between interest rates and aggregate expenditure through net exports. Exchange rate effects reinforce the negative relationship between interest rates and expenditures in the consumption and investment functions. If interest rates rise, other things constant, the domestic currency appreciates and the exchange rate, *er*, falls. Exports fall, and imports rise, reducing net exports and aggregate expenditure. A net export function that describes this relationship would be:

\[NX = NX[Y, Y*, P, P*, er(i),...]\]

with Y ∗ and P ∗ representing foreign incomes and prices respectively.

In Equation 9.4, the variable *er*(*i*) captures the effect of interest rates on exchange rates and exchange rates on net exports. From the foreign exchange market we know that a rise in interest rates leads to an appreciation of the domestic currency that lowers the exchange rate, (∆*er*/∆*i*) < 0. Also, a fall in the exchange rate lowers net exports, (∆*NX*/∆*er*) > 0.

The appreciation of the Canadian dollar that reduced the Canadian/U.S. dollar exchange rate from $1.57Cdn for $1.00U.S. in 2002 to $1.014Cdn to $1U.S. in March 2008 and $0.9814Cdn to $1US in November of 2012 illustrates the point. Although due more to the rise in commodity and energy prices than to interest rate differentials, the lower exchange rate increased imports and reduced the viability of manufacturing based on exports to the U.S. market, or competition with imports. To the extent that interest rate changes affect exchange rates, they also change net exports and aggregate expenditure.

Figure 9.6 summarizes the relationship between interest rates and expenditures, assuming all things other than interest rates and exchange rates are constant. The downward sloping line *A*(*i*) illustrates the inverse relationship between the consumption, investment, and net export components of autonomous expenditure and the interest rate. Starting with interest rate *i*_{0}, the level of expenditure related to interest rates is *A*(*i*_{0}), given by point D on the expenditure function. A fall in interest rates from *i*_{0} to *i*_{1} increases expenditure to *A*(*i*_{1}), moving along the expenditure function to point E. Lower interest rates increase consumption and investment expenditure directly through wealth and cost and availability of finance effects. Lower interest rates also increase net exports through the effects of lower interest rates on the foreign exchange rate. A rise in interest rates would have the opposite effect.

The changes in interest rates and exchange rates are the key linkages between the monetary and financial sector and aggregate demand.