Hi, Can anyone help explain the last last part of this statement? Why will lower savings increase real rates? Thanks for the help!
If GDP growth is forecast to be high, the utility of consumption in the future (when incomes will be high) will be low and the inter-temporal rate of substitution will fall; investors will save less, increasing real interest rates.
Money Supply? With no savings, there’s less funds available for distribution/investments, thus those who want access to those scarce funds must pay more (with higher interest rates).
Lower savings -> increased GDP -> increased r
It’s also the fact that if people aren’t saving their money, they must be spending it, which in turn grows GDP and real rates.
If savings is not happening, interest rate needs to be raised to induce savings.
If GDP is forecasted to be high, it means GDP is presently low compared to the future expectation, thus because there is less income now, the Marginal Utility you derive from consuming now will be higher. You can also interpret this as: In the future when GDP is high, there is enomouse amount of income, and thus as more income is available, the Marginal Utility derived from additional consumption is lower.
Because present utility is greater than future utility due to the lower rate of present income, the Intertemporal Rate of Substitution will be lower.
Also, since the economy is expected to perform better in the future, there is no incentive to save now because the interest rate will be low so as to encourage borrowing and consumption.
It is better to invest in assets that pays off when the economy is weaker because the Marginal Utility of consumption is greater when the economy is weak.
Hope this helps a little.