"Inflation, Wealth And The Real Rate Of Interest"
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1 Econoic Staff Paper Series Econoics "Inflation, Wealth And The Real Rate Of Interest" Walter Enders Iowa State University Follow this and additional works at: Part of the Business Intelligence Coons, Econoic Theory Coons, Finance and Financial Manageent Coons, and the Statistical Models Coons Recoended Citation Enders, Walter, ""Inflation, Wealth And The Real Rate Of Interest"" (1975). Econoic Staff Paper Series This Article is brought to you for free and open access by the Econoics at Iowa State University Digital Repository. It has been accepted for inclusion in Econoic Staff Paper Series by an authorized adinistrator of Iowa State University Digital Repository. For ore inforation, please contact
2 "Inflation, Wealth And The Real Rate Of Interest" Abstract Mundell obtains this result by postulating stable flow deands for assets, whereas as is argued here -- saving and investent arise fro an inequality between actual and desired asset stocks. The odel developed in this paper will include both the stock and flow deands for assets and deonstrates that inflation will peranently alter the real interest rate only if it can change the desired stock of capital. Disciplines Business Intelligence Econoic Theory Finance and Financial Manageent Statistical Models This article is available at Iowa State University Digital Repository:
3 "II^IATION, WEALTH AND THE REAL RATE OF INTEREST" WALTER ENDERS No. 5 March 1975
4 "INFLATION, WEALTH, AND THE REAL RATE OF INTEREST" Robert Mundell has argued that inflation, even when fully anticipated, alters the long-run equilibriu level of the real interest rate (1), "... the oney rate of interest rises by less than the rate of inflation and therefore the real rate of interest falls during inflation. This conclusion is based on the fact that inflation reduces real oney balances and that the resulting decline in real wealth stiulates increased saving,. Real conditions in the econoy are altered by purely onetary phenoenon. The evils or benefits of inflation cannot be attributed solely to the failure of the counity to anticipate it (2)," Mundell obtains this result by postulating stable flow deands for assets, whereas as is argued here -- saving and investent arise fro an inequality between actual and desired asset stocks. The odel developed in this paper will include both the stock and flow deands for assets and deonstrates that inflation will peranently alter the real interest rate only if it can change the desired stock of capital. The desired stock of capital ay be positively or negatively related to the rate of inflation, so that the real rate of return on capital ay decrease or increase due to inflation. The odel will then be used to obtain the tie path of the real interest rate, and the effectsof iproperly anticipated in flation will be shown. Mundell's analysis is based on the following diagra: L Figure 1 M p The curve labeled IS shows the cobinations of real cash balances and real
5 Interest rates which aintain equilibriu in the goods arket. The slope of the IS is positive since:..an increase in the real rate of interest lowers investent causing a deflationary gap, while an increase in real balances lowers saving, causing a copensating inflationary gap (3)." The curve labeled LM shows the cobinations of real interest rates and real cash balances which result in oney arket equilibriu. It has a negative slope for the usual reasons; the higher the opportunity cost of holding cash, the lower is the deand for cash balances. Mundell points out that the IM curve is defined in ters of the noinal interest rate. If, for soe reason, the rate of inflation increases, the LM curve ust shift downward by the rate of inflation, as is shown below. Figure 2 The real rate of interest will decline fro r^ to r^. 1 P Hence, argues Mundell, the Fisher Effect is incorrect. Matheatically: I(r) =S(r, ) ^ = Lfl r - i - TT Where: i = noinal interest rate TT = fully anticipated rate of inflation and: SS -Si Ss ;.M^ dr BL <^M< 1; dr ^ dn ^ P 3i 3r Sr/ ( ^M 5l n ' T3 4. P
6 As should be clear, Mundell's odel ignores the effect of investent on the capital stock and, by necessity, the effect of a change in the capital stock on real output. Furtherore, saving asset accuulation is assued to have no feedback effect upon wealth and next period's consuption and saving, A Portfolio Balance Model In this section, an alternative odel, which captures the stock and flow relationships ignored in the Mundell odel, will be developed. As in the Mundell odel, only two distinct fors of wealth can be held, oney and physical capital. At a point in tie, in which wealth is fixed, asset holders can only allocate their assets between the different fors of wealth but cannot increase the size of their portfolios. The deand for an asset at any point in tie can then be expressed as a proportion of wealth, where the constant of proportionality depends upon the rates of return on all assets. More generally: 1) = y Where: = real per capita cash balances T\ ^ k = real per capita capital 2) k = k (r,, r, w) k' ^k ~ rate of return on capital 3)w=+k e r= expected real rate of return on cash balances, i.e., the negative expected rate of Inflation w = real per capita wealth The discussion of the point in tie asset deand function iplies the following sign restrictions (4): Sr 3" It is assued that the deand for each asset is positively related to the level of wealth and its own rate of return and, hence, negatively related to the rate of return on the alternative asset. Equations 1 through 3 relate Lo deands for assets at a point in tie and
7 convey no inforation concerning asset accuulation. It sees reasonable to assue that saving is proportional to the difference between desired and actual wealth. Since the desired or target level of wealth depends solely upon incoe and the rates of return on assets, real saving can be represented by:,. dw 4) a */ " 'k' " Asset holders do not know Where: w» desired or target level of per capita wealth y s real per capita incoe and: 2 ; < 1 K ay the rate of inflation with certainty and are assued to increase their perception of the inflation rate in such a way that the change in the expected rate of inflation is proportional to the actual inus the expected inflation rate (5), i»e,, 5) dr = a dt ^ r - r e Where: r» actual rate of return on oney, ie., negative rate of inflation. The econoy in question is such that real per capita output is solely a function of the capital/labor ratio and the production function is well behaved, i.e., 6) y = y(k) Where: < y' < 1; y" < 7) r^^ = y'(k) Long-run equilibriu (the particular solution to Equations 1 through 7) requires that desired and actual wealth be equal, and that the expected rate of return on oney equal the actual rate of return on oney. These conditions plus Equations 3 through 6 can be substituted into Equations 1 and 2 in order to yield the steady state solution for oney and capital, i.e., ^ ^ 1') = 1 (y(k ), Where: * designates a steady state solution of the associated 2') k*= k" (y(k*), r^(k*). variable. It should be clear that Bk ar ay be positive, zero or negative, as an
8 increase in the rate of return on oney will increase the desired stock of asset holdings but reduces the desired proportion of capital to wealth. Thus, an in crease in the rate of inflation (decrease in r ) ay increase, decrease or leave unchanged the capital stock and, as a result, the real rate of interest. In contrast to Mundell's conclusion, it has been shown that inflation ay lead to a reduction in real cash balances without producing a peranent change in the real interest rate. Equations 2 through 7 (since Equation 1 is not independent of Equations 2 6» and 3) can be used to obtain the tie path for k, r, w, r,, and y. Allowing K D to represent the differential operator, and retaining only the linear ters of a Taylor Expansion, the coefficient atrix post ultiplied by the colun vector of unknowns can be represented by: V H -dk" 3w /it 5w Sy. 3w' d^k 3y 3k arj^ 3k^ * w Setting the deterinant of the coefficient atrix equal to zero, the solution set for D will yield the characteristic roots of the syste. The deterinant of the coefficient atrix ( k) is: a+3") -/1 + ^ (I - ak-' ^ 4- a w ay ak SX ^ 3w_ ar^^ 5^1^ ^ Thus; = -g ; r2 = -a (1 - aw * aw avv ay ak'^ ar ak k ark,3k 13«*3k ^ari(. ' ar^ 1 - ^^k The two characteristic roots are both negative, thus the syste is stable. ak Regardless of whether the long-run value of the real interest rate is invariant
9 «with respect to the rate of inflation, the characteristic roots show that the real interest rate changes during the transition period. Further, the saller is the slower is the adjustent of the expected to the actual rate of in flation -- the longer it will take for the syste to return to long-run equilib riu fro any given displaceent. Thus, Incorrectly anticipated Inflation acts to delay the return to full stock equilibriu. The view taken in this paper is that individuals deand a stock of wealth and that saving and investent are attepts to equilibriate desired and actual asset holdings. In this approach, equilibriu--in each period of tie--requires that the desired accuulation of wealth equal the actual accuulation of wealth. Since individuals, however, have a desired or target level of asset holdings, saving and investent in a period will increase actual wealth and thus change desired saving and investent in successive periods. Thus, it is clear that "real conditions in the econoy are altered by purely onetary phenoenon", but this has been shown to be unabiguously true only in the short run. In the long run, it has been shown that it is possible for real cash balances to fall during inflation while the real interest rate ay rise or fall depending upon whether cash balances and capital are copleentary or substitute assets. This is in direct contradiction to Mundell's explanation of why the long run rate of interest is not invariant with respect to the rate of inflation.
10 FOOTNOTES 1. See R. A. Mundell, "Inflation, Saving, and Che Real Rate of Interest," in R. A, Mundell, Monetary Theory. (Pacific Palisades, Calif., 1971), pp , R. A, Mundell, "Inflation and Real Interest," Journal of Political Econoy, (June, 1963), pp , 2. R, A, Mundell (1971), pp R. A. Mundell (1971), p For a detailed discussion of "point in tie" asset deand equations, see J. Tobin and W. Brainard, "Pitfalls in Financial Model Building," Aerican Econoic Review, (May, 1968). 5. The target level of wealth can be allowed to depend upon expected incoe and the expected rate of return on capital without changing the ajor conclusion^ of this paper.
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