Academic journal article Economic Perspectives

Interest Rates and the Timing of New Production

Academic journal article Economic Perspectives

Interest Rates and the Timing of New Production

Article excerpt

Introduction and summary

Policymakers are naturally interested in the effects of interest rates on various economic activities. This article studies how interest rates affect entrepreneurs' propensities to initiate new projects. Since the implementation of new ideas and production techniques is an important engine driving long-run economic growth, the effect of real rates on this activity should be of particular interest. This article illustrates that the effect of interest rates on the incentives to implement is not monotonic. Starting at high interest rates, a fall in the interest rate will spur entrepreneurs to implement projects more rapidly. But lowering interest rates even further will only persuade entrepreneurs to delay.

Ordinarily it would be difficult to measure the extent of delay, since we cannot easily identify when an economic agent first received the opportunity to bring a project to fruition. To get around this, we look at initial public offerings (IPOs). Although the decision to issue an IPO may reflect a host of considerations, Jain and Kini (1994) find that IPOs appear to be related to growth in investment and sales. More importantly, we can measure the amount of time that transpired between when a firm was founded or incorporated and when its IPO was issued, so we have a reasonable proxy for the delay time. Data on the time it takes firms to go public show a non-monotonic correlation between interest rates and the age at which the firm goes public. High rates of interest induce a delay and discourage investment for the usual reason, namely that when future income is discounted more heavily, it is not worthwhile to sacrifice current resources. Very low rates of interest, however, also discourage investment, because profits that are foregone during the delay are not as costly in comparison with the gains to delaying.

Chetty (2001) has shown that irreversibility of investment can lead to a non-monotonic relation between interest rates and investment. In his two-period model, if investment is postponed to the second period, the firm can better react to news about demand conditions. Aside from offering a different model, we also provide evidence on the non-monotonicity. In earlier work, Jovanovic and Rousseau (2001) show that the incentive to delay implementing a project gets stronger as the interest rate falls. In that paper, we also provide an information-theoretic rationale for the gains to waiting, but do not give any evidence.

The non-monotonicity of physical investment in the interest rate stems, ultimately, from the fact that the firm is giving up profits while it waits to implement its project. The decision to wait itself delivers information, that is, human capital, hence what is really happening is a substitution of one form of capital for another. We comment on this again in the conclusion and the implications that it may have for countries like Japan that are experiencing low investment, in spite of enjoying very low interest rates.

In the next section, we explain the model, and in the following section we describe its main implications for the data that we have. Then, we test those implications and discuss some related literature.

The model

The following model is a simplified version of Jovanovic and Rousseau (2001). Suppose the firm lives forever and has the property rights to its project. When implemented, the project produces output using knowledge and physical capital k. The firm starts to receive net revenue cash only after it implements the project. Let T denote the waiting time until implementation. Suppose that while it waits, the firm's potential output is

y = f(T).

We assume that f increases with T but at a diminishing rate, as drawn in figure 1. In this formulation the firm starts receiving y only after implementing the project. At that point the project starts yielding profits. Moreover there are no direct costs. …

Search by... Author
Show... All Results Primary Sources Peer-reviewed

Oops!

An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.