Investment, Interest Rates, and the Effects of Stabilization Policies

THE RESPONSE of investment expenditure to changes in interest rates is at the heart of any analysis of stabilization policy. The more sensitive the response, the more potent is monetary policy and the weaker is fiscal expenditure policy. The stimulus of lower interest rates on investment is one of the principal channels of monetary influence in virtually all macroeconomic theories. On the other hand, the negative influence of higher interest rates on investment may inhibit the macroeconomic effect of expenditure policy. The net effect of government expenditures on gross national product has been and remains the single most important source of disagreement over stabilization policy among economists. My purpose here is to examine the empirical evidence on the interest response of investment with the hope of narrowing the disagreement about the effects of expenditure and monetary policies. Though the evidence is disappointingly weak, it does suggest that the modem Keynesian view embodied in large-scale macroeconometric models-that the expenditure multiplier is around 1.5 -and the simple monetarist view-that it is essentially zero-are both incorrect. The most reasonable value lies in the middle, perhaps at 0.7. Unfortunately, the evidence is probably not strong enough to convince the firm adherent of the other two positions.