Academic journal article Economic Inquiry

Investment and the Nominal Interest Rate: The Variable Velocity Case

Academic journal article Economic Inquiry

Investment and the Nominal Interest Rate: The Variable Velocity Case

Article excerpt


Models treating money either as a consumer good or as a producer good are encompassed by a model in which both households and firms use money as a buffer between receipts and expenditures. A rise in nominal interest rates increases resources devoted to intermediation, while discouraging purchases financed from accumulated cash. If investment is financed from contemporaneous earnings, there is a tendency to substitute out of consumption and into investment when interest rates are high. Greater resources devoted to intermediation generate a negative wealth effect. The net impact on investment is ambiguous.


The relationship between investment and the nominal interest rate in an economy where the cash balances of households and firms are rigidly linked to their respective expenditures has been examined by Koenig [1987b]. In such an economy the nominal interest rate acts like a tax on agents' purchases. As a result, households are inclined to save, rather than spend, when the nominal interest rate is relatively high. Provided that, at the margin, firms are able to finance at least some of their capital spending out of contemporaneous earnings, this increase in desired saving is only partially offset by a decrease in desired investment. Realized investment is thus greatest when the nominal interest rate is high in comparison to its own moving average--a "short-run Tobin effect."

This paper extends Koenig's analysis to the case in which households and firms, at a cost in terms of real resources, are able to increase the velocity of money. In this context it is shown that the short-run Tobin effect may be reversed. Intuitively, when the nominal interest rate is high, consumption of financial services by households and firms may rise to such an extent that any decline in the consumption of nonfinancial goods and services is overwhelmed, reducing the resources available for investment.

As in the earlier paper, I allow for the possibility that some fraction, 1-u, of firms' investment expenditures can be financed from contemporaneous earnings. Unless u equals zero, there is a "Stockman effect" [1981]: a tendency for investment to be depressed whenever the nominal interest rate is expected to be higher, on average, in the future than it has been in the past. When u equals unity, so all investment must be financed out of accumulated assets, the money balances of the representative firm can be interpreted as an argument of its production function. Regardless of the value of u, the money balances of households may be thought of as an argument--along with gross household spending--of an indirect utility function. Thus both of the most frequently used methods of modeling the role of money--as an argument of the household utility function, and as an argument of the production function--are special cases of the model developed here.

This is a substantially less restrictive framework than that employed by Fischer [1979], Sweeney [1984], Cohen [1985], and Obstfeld [1985], each of whom has also examined the effects of anticipated policy in an economy where the velocity of money is variable.(1)

Section II discusses the utility and profit maximization problems facing households and firms, respectively, and shows how the behavior of economic agents is affected by the presence of real costs of financial management. A dynamic analysis is undertaken in section III, and it is shown that the short-run Tobin effect may operate in reverse. A summary concludes the paper. Throughout, agents are assumed to possess perfect foresight.



Imagine a world in which each household receives wage and dividend income at discrete intervals, but desires to purchase and consume output continuously through time. …

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