The Inverted Leading Indicator Property and Redistribution Effect of the Interest Rate

Abstract

The interest rate at which US firms borrow funds has two features: (i) it moves in a countercyclical fashion and (ii) it is an inverted leading indicator of real economic activity: low interest rates today forecast future booms in GDP, consumption, investment, and employment. We show that a Kiyotaki-Moore model accounts for both properties when interest-rate movements are driven, in a significant way, by self-fulfilling shocks that redistribute income away from lenders and to borrowers during booms. The credit-based nature of such self-fulfilling equilibria is shown to be essential: the dynamic correlation between current loanable funds rate and future aggregate economic activity depends critically on the property that the interest rate is state-contingent. Bayesian estimation of our benchmark DSGE model on US data shows that the model driven by redistribution shocks results in a better fit to the data than both standard RBC models and Kiyotaki-Moore type models with unique equilibrium..

International credit markets and global business cycles

“…The purpose of this section is to extend the proof in Pintus et al . (), obtained in a closed‐economy setting, to show that steady‐state indeterminacy arises also in our two‐country setting. This happens when loans are such that the interest rate that applies to current debt repayment is variable (i.e.…”

“…; Pintus et al . ). In contrast, we show that country‐specific shocks to productivity or leverage do not induce co‐movement across countries in output and other key aggregates, unless strong direct (spill‐over) effects are assumed.…”

“…(), and Pintus et al . (). In particular, we extend the small‐open‐economy settings of, among others, Kocherlakota (), Pintus and Wen (), and Kaas et al .…”

“…The reason why self‐fulfilling equilibria arise in our two‐country model is essentially similar to that detailed in the closed‐economy version with variable interest rate studied in Pintus et al . (). In a nutshell, expectations about the world interest rate can be self‐fulfilling because they move credit supply and demand in the same direction.…”

“…As in Pintus et al . (), today's interest rate is not uniquely pinned down and there is one‐dimensional indeterminacy. Such indeterminacy comes from the fact that loans feature a variable rate, as emphasized in Section 2.2 using a simplified setting.…”