As per my earlier post, this follow up aims to understand how uncertainty influences monetary policy. Although we will use the lens of investment, these arguments hold for planned expenditure in the economy more generally.
Let’s refer to our graph again:
The I* can now be thought of as the level of investment where potential level of output is met, given what we discussed in that post. Our investment function then will define potential output, and the term B reflects the interest sensitivity of expenditure on investment which in turn translates into output.
Given our simple investment function: I*= A-Br, two scenarios are discussed:
- When we lower B (assuming a corresponding shift in A that leaves I* unchanged), the curve rotates from orange to light green. As we can see from the intersects with I* curve, the level of investment in both curves doesn’t change – but instead how sensitive the firm is to the interest rate has changed. The lower interest rate sensitivity doesn’t imply we need a different interest rate – in this case we don’t. Instead it tells us merely that a given change in interest rates leads to a small change in investment.
- When we lower A, the investment curve (in purple) shifts to the left, indicating that for a given interest rate firms want to invest less.
Uncertainty will tend to change both A and B.
- Uncertainty about the future may make firms less willing to change investment plans, which in turn makes them less responsive to changes in interest rates (lower B).
- Uncertainty about the future with firms who are risk averse may see them reduce investment irrespective of the interest rate (lower A).
- When there are irreversible fixed costs of investment an increase in uncertainty may increase the value of delaying investment (lowering A and B)
It is important that uncertainty changes both. If it only changed B (in the way shown above) then uncertainty would not appear to have any impact on the economic cycle or activity – instead simply changing the unobserved interest sensitivity of investment as long as the economy is at or near potential output.
A shock that reduces investment at the current interest rate, which an uncertainty shock may, will lead to investment, spending, and output below potential. As a result, this framework gives us a way to think about how a central bank will act.
A central bank predominantly decides on setting the interest rate and will provide high powered money and liquidity as required to meet that target rate.
If we are in a situation when the A curve shifts back, the Bank cuts the interest rate in order to lift the investment.
What if the A curve shifts left and the B curve rotates? In that case, given the observed change in I for that r the Central Bank needs to cut interest rate even more in order to increase investment sufficiently to deal with the shock!
This implies that knowing whether the shock reduces the interest sensitivity of investment as well as observing how investment has declined will matter for deciding on the right interest rate – using data that doesn’t account for uncertainty will suggest an optimal interest rate that is higher than the rate that will actually achieve I*.
How does it relate to the current NZ case?
NZ’s current interest rate (OCR) is 1% with the potential to be reduced more in the near future. This might lead us to a zero lower bound situation, the principles of which I’ve described in an earlier post.
When we are in a situation where both the A curve shifts and the B curve rotates, the zero lower bound is even more binding.
As a result, situations of heightened uncertainty increase the risk that we end up in a zero lower bound situation. In a world of heightened uncertainty it is probably worth asking whether fiscal and monetary authorities can be friends to ensure any such crisis could be dealt with in a timely manner.