Capital markets expectations- vol 2 page 202
Loose fiscal policies (large deficits and lower taxes) increase the level of real interest rates because: Domestic private sector is induced to save more/invest less. and additional capital must be attracted from abroad.
How does that work? We need more investments to generate economic growth right??? Loose monetary policy results in higher inflation (actual and expected).
Most, if not all, economic variables depict a convergent system. This means that no economic variable can’t go unlimited up or down for ever.
A loose fiscal policy is intended to rise GDP by directly investing or spending public resources. It’s great!
What forces prevent this strategy from being constantly or unlimitedly applied? (1) The rise of real interest rates, (2) crowding out effect, (3) expected long-term efficiency of public spending/investing, etc
So, loose fiscal policies will be a one-shot strategy and are expected to be counter-cyclical. A government with a loose fiscal policy for an extended period of time will see its country perish. Example: Venezuela.
If I understand your question, you are concerned about how a rise in interest rates will provide future economic growth. As I said first, the system is dynamic but must remain convergent…
Assuming we are in the depressed market:
One option is a loose fiscal policy > GDP grows > Real interest rates go up > Loose fiscal policy again? Bad idea, stay away > Higher rates compared to international rates attract capital from abroad > Domestic savings increase > Real interest rates may go down > Higher investments and spending > GDP grows > Loose fiscal policy again? Bad idea, GTFO…(and so on)
This dynamic system is convergent. It means variable fluctuate and affect the other variables in order to maintain order. Nonetheless, the system can be shocked by external (exogenous) variables like political events, natural disasters, generalized craziness of million of grannies, etc. and require a new strategy (fiscal or monetary) to bring it back to is long-term (potential) growth path.
The same analysis can be done for a tight fiscal policy, loose or tight monetary policy or a combination of both. Central banks around the world (assumed to be independent from governments) use complex econometrical models to assess and quantify the impacts of this kind of macro decisions. It is quite interesting.
Thanks for your response. I am still not clear about the relationship between rising GDP and rising interest rates. Also how increase in savings is good but investment is not !!
We are talking about a specific case here: the impact of a loose fiscal policy on the economic variables. A loose fiscal policy will increase GDP and will also put pressure on real interest rates (increase). Why a loose fiscal policy would increase real interest rates? In most of the cases, a loose fiscal policy is funded by government debt, which means the government goes to the market and sell bonds. The thing is that at each new issuance of bonds, the yields will be higher in order to make them attractive enough to the remaining investors willing to buy public bonds.
The increase in rates will make savings more attractive than investing in the real market (savings increase, investments decrease). Also, higher rates will attract capital from abroad (will depend on how open to foreign capital the country is). Important to note this are the consecuences of a loose fiscal policy, not the initial move.
Sorry for the late response.
I have the same question: how loose fiscal policies increase the level of real interest rates?
Then I did some googling and found from “https://www.econlib.org/library/Enc/FiscalPolicy.html”
Fiscal policy also changes the composition of aggregate demand. When the government runs a deficit, it meets some of its expenses by issuing [bonds]. In doing so, it competes with private borrowers for money loaned by savers. Holding other things constant, a fiscal expansion will raise interest rates and “crowd out” some private investment, thus reducing the fraction of output composed of private investment.