Why Real Interest Rates Were So Low in the 1970's

Abstract

The economic turmoil of the 1970's resulted in record postwar increases in inflation, unemployment, and nominal interest rates. Yet, it was declines that were hardest to explain. The average real value of a share of common stock plummeted. Productivity growth evaporated. Real interest rates, measured as the spread between nominal interest rates and the inflation rate, turned negative (see Table 1). Over the past decade, an explosion has occurred in the amount of attention paid to the relationship between nominal and thus real interest rates and expected inflation rates. A good deal of this effort has been directed toward empirical analysis of the Fisher neutrality hypothesis that nominal rates respond one for one with expected inflation rates. Most empirical tests of the Fisher hypothesis have been bivariate; interest rates were regressed on a constant and on actual or expected inflation measures. Estimates of the impact of inflation on interest rates in these and even in extended models are often significantly below one, are often statistically imprecise, and tend to be unstable over time.' The middle column of Table I reflects this. The coefficient of inflation on nominal interest rates there drops from 0.78 to 0.59 in the latter 1970's. Another branch of work on nominal interest rates has concentrated on the institutional impediments to the Fisher hypothesis. Robert Mundell and James Tobin demonstrate that nominal rates change by a smaller amount than the expected inflation rate does when a real balance effect exists and money pays no interest. Michael Darby and Martin Feldstein, on the other hand, argue that nominal rates should exhibit a greater-thanunity response to expected inflation due to the nature of U.S. income tax laws.2 Here I estimate the relation between interest rates, expected inflation, and real forces. Such estimates are required for evaluating the effects of inflation on saving, investment, the distribution of income, and the redistribution of wealth. To generate estimates of the net impact of these various factors on interest rates and to avoid the identification and simultaneity problems masked, but not often remedied, by instrumental variables techniques, I employ only exogenous regressors. To buttress the argument, I examine the individual links in the chain which are summarized in the reduced form. The novel aspect of the model presented in Section I is its addition of aggregate supply shocks to the determination of interest rates. I trace the reduction in the supply of complementary factor inputs in the 1970's to a decline in the demand for capital and therefore in real interest rates. The inclusion of this supply force along with expected inflation allows one to distinguish between two, offsetting effects on interest rates: the depressing effect on real rates through lower investment demand and the elevating effect on nominal rates of higher expected inflation. The results in Section II not only strongly support the economic and statistical importance of supply shocks on real interest rates, but also resolve some longstanding interest rate puzzles. Allowing for the impact of factor supply produces a significant estimated response to expected inflation for a sample that ends prior to late 1960's. The magnitude *Assistant professor, School of Business Administration, University of California-Berkeley. I would like to thank George Akerlof, Robert J. Gordon, Robert A. Meyer, Joe Peek, Janet Yellen, the members of the Economic Analysis and Policy seminar at Berkeley, participants at the NBER Conference on Inflation and Financial Markets, and anonymous referees for helpful comments. Data Resources supplied data and computational services. Financial support was provided by the Berkeley Program in Finance and NSF grant SES8109093. Linda Pacheco supplied able research assistance. Errors of omission or commission are my responsibility. 'See William Gibson, David Pyle, John Carlson, and Thomas Cargill and Robert Meyer. 2Maurice Levi and John Makin derive the reducedform effect of expected inflation on nominal interest rates as a function of the structural parameters.

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