Gazing at r*: A Hysteresis Perspective

Paul Beaudry, Katya Kartashova and Césaire A Meh

RBA Annual Conference Papers from Reserve Bank of Australia

Abstract: Despite current high inflation and a monetary tightening cycle, the market's evaluation of long-term real interest rates remains very low in most advanced countries. This is consistent with the view that neither monetary policy nor inflation shocks — which are both nominal phenomena — are likely to effect long-run real interest rates. This paper presents both theory and evidence that put into question this simple dichotomy between real and nominal phenomena due to asset accumulation behavior that favours the emergence of more than one steady state value of real interest rates (r*) and thereby creates hysteresis. Our main building block is household saving decisions that incorporate both inter-temporal substitution and retirement forces. When households trade off these two saving motives, we show how this can give rise to C-shaped asset demands and the possibility of more than one steady state equilibrium real interest rate. Since many macroeconomic models predict that long-run asset demands are increasing in interest rates, as opposed to C-shaped, we provide evidence from household balance sheets that runs counter to the former and favours the latter. A central contribution of the paper is to show that when r* is not unique due to C-shaped asset demands, monetary policy can greatly influence long-run real interest rate outcomes. In particular, we show that an aggressive inflation targeting regime can make a high-real-rate outcome fragile to small negative inflation shocks and favour the convergence to a low (possibly negative) real-rate environment. However, we also show that either a large positive inflation shock or a large increase in public debt can bring back an equilibrium with high real rates, which could surprise the market in the current environment.

Keywords: real interest rates; wealth-to-income ratio; saving rates; inter-temporal substitution; retirement motives; C-shaped long-run asset demand; inflation; general equilibrium (search for similar items in EconPapers)
Date: 2022-06, Revised 2022-12
New Economics Papers: this item is included in nep-cba, nep-fdg and nep-mon
Note: Paper presented at the RBA's annual conference 'The Causes, Challenges and Consequences of the Low Interest Rate Environment', Sydney, 28–29 June 2022.
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