Long Run Interest Rate

Have you ever thought about what life would be like if interest rates stayed higher for a long period of time? Things would get more expensive, there might be less spending, etc. Long-term interest rates have been shown to have a significant impact on practically all important financial choices made by individuals, organizations, and governments. It's in the best interest of everyone to gain knowledge about long-run interest rates. To learn about long-run real interest rates, differences between long-run and short-run, Keynes' theory, and more, keep scrolling!

Long-Run Real Interest Rates

The real (inflation-adjusted) interest rate is considered to be one of the most important components of an economy. It influences household mortgage and vehicle loan choices, company decisions on establishing plants and investing in assets. In summary, the real interest rate is an important consideration in practically every choice that families, corporations, and governments make as to whether to purchase now or later. A variety of underlying causes influence the real interest rate. Some are temporary and have only a brief impact on interest rates. For example, changes in price of oil and salary adjustments.

Other basic issues are more important to politicians (and economists) since they affect the long-run real interest rate. Forecasts of the long-run rate are useful to financial strategists in determining the best quantity and level of governmental debt issuance each year.

Long-Run Interest Rate Diagram

The simplest way to illustrate the long-run interest rate is with the following diagram:

Fig 1. - Long-run interest rate

The money supply and demand curves are depicted in Figure 1 above prior to and after the government injects money into the economy. We begin by assuming that the economy is at point 1 and that the money supply is at Q₁. The crossing of the initial money demand curve (MD₁) with the money supply curve (MS₁) determines the starting equilibrium interest rate, which is r₁.

The initial monetary policy effect of increasing the money supply (from MS₁ to MS₂) leads to a reduction in the interest rate (from r₁ to r₂). The position of the economy is now at point 2 at the intersection of the initial money demand curve (MD₁) and the new money supply curve (MS₂).

However, the long-run effect of this monetary policy is that the overall price level in the economy rises due to increased money supply. As people now need more money to pay for the same amount of goods and services the money demand increases. This is represented by a shift in the money demand curve (from MD₁ to MD₂). The final equilibrium is at point 3 and a higher interest rate which is equivalent to the initial - at r₁.

Decrease in Interest Rates

Borrowing becomes less expensive when there is a decrease in interest rates. This promotes spending. As a result, there is greater aggregate demand and economic expansion. This rise in demand might also result in inflation fluctuation.

A decrease in interest rate typically causes:

• Lower cost of borrowing. Lower interest rates reduce the expense of borrowing. It encourages individuals and businesses to borrow money to support more spending.

• An increase in asset costs. Low rates appeal to consumers in the sense that it invites them to purchase assets such as real estate. This would result in an increase in property values and, as a result, in wealth of property holders.

• Help in lowering motivation to save. Keeping money at lower interest rates yields a lower return. This reduced temptation to save will push people to splurge rather than save.

• Mortgage interest payments are reduced. The price of mortgage repayments will be reduced when interest rates decline. Households will have greater disposable income as a result, which typically causes an increase in expenditure.

Differences in Long-Run and Short-Run Interest Rates

A long term interest rate is one that is used for a lengthy duration, generally more than ten years. These rates are typically more stable because any big changes that occur in the near future are smoothed out over time. Long-run interest rates are linked to securities such as government bonds, bank deposits, and long-term bank loans that typically cover several years.

Short term interest rates often operate for shorter time periods and are related to securities and capital assets that have duration of less than a year.

Long-run interest rates are also generally greater than short-run interest rates since there's usually a larger chance of delinquency with long-run interest. Why? Well, because money borrowed is secured for longer duration. Short-run interest rates are prone to more instability since economic activity could have a rapid and substantial influence on these rates. Long-run interest rates, on the other hand, may readily balance out over time.

Furthermore, short-run rates influence money demand more-so than long-run interest rates because the choice to keep money entails weighing the convenience of keeping cash against the return from financial assets that accumulate in the near future, usually within less than a year.

Expansionary Policy Effects on Long-Run Interest Rates

The primary goal of expansionary policy is to increase overall demand in order to compensate for deficiencies in private demand. Expansionary policy aims to stimulate spending by pumping cash into the economy, either directly or through greater financing to firms and buyers.

Over-extension of debt is one of the long-run problems of these policies. Because money is plentiful, both businesses and consumers reap the benefit of reduced interest rates by taking on more debt. Debt levels that are too high for a long time are unsustainable and can have disastrous consequences.

Another big issue over the long-run with expansionary policies is the high likelihood of inflation. If inflation is not controlled, it could cause hyperinflation, which has a significant negative effect on the economy. Prices of goods rise faster than salaries during periods of strong inflation, while real wages, along with living standards, decline.

Calculating Real Interest Rate

The real interest rate is calculated by figuring out the gap in between the nominal interest rate and predicted inflation rate for the coming year. The inflation rate is calculated as the consumer price inflation rate from one year to the next, usually using numbers from the December of one year and the following December. In terms of inflation projections, we use the inflation rate from the current year to get an idea of the rate of inflation for the following year. To get the real interest rate in a long-run equilibrium, economists use 11-year focused moving averages.

The formula that is used is:

Keynes' Theory on Interest Rates

While the typical go-to answer regarding what drives interest rates is supply and demand, Keynes had a different idea. Keynes hypothesized that the U.S. Central Bank possesses a decisive command on the country's government bonds' long-term interest rate, primarily via its policy rate and fiscal policy activities. He contended that their policy rate choices determine the short-term interest rate and consequently the short-term interest rates have a significant impact on long-term interest rates. Basically, he believed that in economies today, central banks have complete authority of short-term interest rates, and that markets form expectations of coming interest rates in the future by regularly reviewing whatever the central bank says and does.

If the interest rates are truly determined by just supply and demand, there would be a substantial link between long-run interest rates and budget deficits within the government. But, if Keynes is right, then there would be a clearly shaky and unstable link among the long-run interest rates and budget deficits. This is due to the fact that the government deficit would be just one of several indicators that would be evaluated when predicting future government movements.

A few economists set out to find out which theory holds more weight. After carrying out their research and looking over more than 10 years of data, they found their results to be extremely varied. They found that the deficit has no discernible influence on interest rates in the long-run.¹ When there is some sort of influence, it is usually transitory and goes away soon. This data is consistent with the Keynesian determination theory of interest rates. In cases where the deficit expands and dominates the financial markets, those watching the central bank and government tend to react prematurely and sell their bonds.

This is most likely because they believe that bigger deficits will result in greater inflation in the future. But due to the poor link between the budget deficits and inflation, this isn't necessarily the best or the correct move to make.