DF201 Exam|Question 1

1. To what extent does empirical evidence support the view that higher real interest rates lead to increased quantity and improved quality of investment?

From title link, it shows that it does not increase quantity of investments but does increase the overall quality.
A rise in interest rates could reduce saving if debtors' propensity to save is higher than creditors'. It is then possible that lenders' current consumption might increase and that it might increase more than borrowers' current consumption fall.
Also, it may be the case that savers in developing countries are not behaving as utility-maximizers, but have some kind of fixed target for their savings.



References:
UNCTAD No. 40, August 1991, Yilmaz AKYÜZ & Detlef J. KOTTE, Financial policies in developing countries: Issues, and experience
The main question is why a similar policy approach has generated different results in different countries. Two basic factors stand out:

Macroeconomic stability is essential. [Note: from research and most notably the East Asian Crisis it is not the sole factor.]
...the degree to which governments have been able to ensure that the support and protection provided by them have been well-targeted and used for the purposes intended rather than as a handout.

In the handful of cases of financial liberalization where these problems were avoided, two factors were especially in evidence:

Financial liberalization came often not before a considerable degree of industrialization had been achieved, and it came out of strength rather than as a response to weakness.
Liberalization was undertaken only to the degree compatible with the pursuit of an active industrial policy.

...pushing interest rates up in order to match inflation can make matters worse by reducing incomes [borrowers] and increasing price instability which, in turn, can reduce savings and distort resource allocation further.

Higher interest rates could discourage corporate investment from retained earnings, and also reduce aggregate private savings by transferring income from firms to households.

Fry, Maxwell (1978)'Money and Capital or Financial Deepening in Economic Development'
Journal of Money, Credit and Banking, Vol. 10 No 4, November 1978, Ohio State University Press, USA

Giovannini's Critique of Fry

From notes: In Giovannini's results, the interest elasticity of savings appears to be not statistically significant and in several cases it is negative; and so Giovannini doubts the very hypothesis that Fry felt his won estimates supported.

The models were based on savings behavior and the data was only on aggregate domestic savings which included the Government sector. Household behavior over time is also reflected in life cycle model or permanent income hypothesis and portfolio allocation (added).

I agree with Giovannini thatRicardian Equivalence is not a worthy argument for keeping aggregate savings together as the two "sorts of savings as substitutable".

Ricardian equivalence, (also known as Barro-Ricardo equivalence proposition or Ricardian rent), is an economic theory which suggests that government budget deficits do not affect the total level of demand in an economy.

This is because tax payers have perfect knowledge about the deficit and will increase savings in the exact amount as "rational expectations".

# A perfect capital market where any household can borrow or save as much as is required at a fixed rate which is the same for all persons at a given date.
# The path of government spending is fixed
# Intergenerational concern. The tax rise required may not occur for centuries, and will be paid off by the great-great-grandchildren of the population around at the time the debt was incurred.

National savings may then be unaffected by changes in aggregate domestic savings, anyway.

Aggregate savings as a residual, that is that aggregate savings in developing countries was derived as a residual of some other function as in: GNP-C.