Why Lower Rates Unambiguously Raise Aggregate Demand

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The substitution effect—lower rates making things now cheaper compared to later and so leading consumers, firms and the government to buy more is easy to understand.

And low rates cause dollars to flow abroad; many unwanted US dollars abroad then raises net exports by weakening the dollar.

But what about wealth effects?  Lenders are hurt by rates going down. Financially worse off, they might spend less.

The key to the analysis here that lenders and borrowers come in pairs. For every lender there is a borrower and for every dollar lent, there is a dollar borrowed. There are many conceptual two-sided coins.

Thus, whenever a lender is hurt by lower rates, a borrower is helped by an equal amount. And borrowers are likely to have a higher marginal propensity to spend than lenders.

After all, borrowers are borrowers because they are good at spending, while lenders are lenders because they are good at saving.

I say "marginal propensity to spend" rather than "marginal propensity to consume," because firms investing and governments spending are important borrowers. For the purposes of thinking about aggregate demand, extra spending includes extra consumption investment and government purchases, but not extra imports.

Analytically, the government is the one borrower we need to zoom in on. When rates go down in a recession, when everyone is crying for help, it is a cinch that the government will have a substantial marginal propensity to spend—almost certainly bigger than its bondholders' marginal propensity to spend.

But when rates go up, the government may not manage to cut non-interest spending. That is the one time it is unclear which way rates will affect aggregate demand, though the response of private components of aggregate demand may still mean higher rates lead to lower aggregate demand even if the government doesn't cut non-interest spending. Higher rates reducing aggregate demand is crucial for the Fed's ability to ward off hyperinflation. The opposite danger of lower rates not raising aggregate demand is very implausible politically.

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The substitution effect—lower rates making things now cheaper compared to later and so leading consumers, firms and the government to buy more is easy to understand. And low rates cause dollars to flow abroad; many unwanted US dollars abroad then raises net exports by weakening the dollar. But what about wealth effects? Lenders are hurt by rates going down. Financially worse off, they might spend less. The key to the analysis here that lenders and borrowers come in pairs. For every lender there is a borrower and for every dollar lent, there is a dollar borrowed. There are many conceptual two-sided coins. Thus, whenever a lender is hurt by lower rates, a borrower is helped by an equal amount. And borrowers are likely to have a higher marginal propensity to spend than lenders. After all, borrowers are borrowers because they are good at spending, while lenders are lenders because they are good at saving. I say "marginal propensity to spend" rather than "marginal propensity to consume," because firms investing and governments spending are important borrowers. For the purposes of thinking about aggregate demand, extra spending includes extra consumption investment and government purchases, but not extra imports. Analytically, the government is the one borrower we need to zoom in on. When rates go down in a recession, when everyone is crying for help, it is a cinch that the government will have a substantial marginal propensity to spend—almost certainly bigger than its bondholders' marginal propensity to spend. But when rates go up, the government may not manage to cut non-interest spending. That is the one time it is unclear which way rates will affect aggregate demand, though the response of private components of aggregate demand may still mean higher rates lead to lower aggregate demand even if the government doesn't cut non-interest spending. Higher rates reducing aggregate demand is crucial for the Fed's ability to ward off hyperinflation. The opposite danger of lower rates not raising aggregate demand is very implausible politically.

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