Default-Free Interest Rates and Economic Growth

[ishwar_jindal]

Section 3.2 in reading 55 says below
“If there is a known independent change in the real GDP growth, or a change that can be forecasted perfectly, then an increase in real GDP growth should lead to an increase in the real default-free rate of interest because more goods and services will be available in the future relative to today. The result is that investors’ willingness to substitute across time will fall, resulting in less saving and more borrowing, so that the real default-free interest rate increases”
Can someone help clarify below two queries
1. How come availability of more goods and servuces in future will cause increase in real default-free interest rate?
2. if future real risk free interest rate will increase then why people will save less? Shouldn’t people actually save more because returs are higher in future so payoff will be higher.

 

[Harrogath]

1. How come availability of more goods and servuces in future will cause increase in real default-free interest rate?
If you expect that more goods and services will be available in the future, it means that the economy is going to better. If the increase is in Real GDP and inflation mantains, then the economy is better than before because there is more production (physical, not just inflated prices). Therefore, agents expect more income and more spending as well, so due limited stock of money between time 0 and time 1, the real interest rate will rise because there is higher demand for money (people want to spend more).
2. if future real risk free interest rate will increase then why people will save less? Shouldn’t people actually save more because returs are higher in future so payoff will be higher.
As stated above, real default-free rate will increase because real GDP increased, that’s the first move. Due to the increase in GDP was from the real side (higher physical production not just inflated prices), then people won’t react to the relatively higher real rate because they have now more income, so their necessity to save is lower than bofore and will only react to an even higher real rate, not to the last one.
This could explain why some countries experiment high real rates for prologend periods tied to high Real GDP growth rates also for prolonged periods.
Hope this helps

 

[ishwar_jindal]

Thanks. It is helpful. Sometimes concepts so interlinked that one tend to think in one direction and looses the handle on other dimension.