Working Paper

The Inverted Leading Indicator Property and Redistribution Effect of the Interest Rate

Abstract: The interest rate at which US firms borrow funds has two features: (i) it moves in a countercyclical fashion and (ii) it is an inverted leading indicator of real economic activity: low interest rates today forecast future booms in GDP, consumption, investment, and employment. We show that a Kiyotaki-Moore model accounts for both properties when interest-rate movements are driven, in a significant way, by self-fulfilling shocks that redistribute income away from lenders and to borrowers during booms. The credit-based nature of such self-fulfilling equilibria is shown to be essential: the dynamic correlation between current loanable funds rate and future aggregate economic activity depends critically on the property that the interest rate is state-contingent. Bayesian estimation of our benchmark DSGE model on US data shows that the model driven by redistribution shocks results in a better fit to the data than both standard RBC models and Kiyotaki-Moore type models with unique equilibrium.

Keywords: Endogenous Collateral Constraints; State-Contingent Loan Repayment; Redistribution Shocks; Multiple Equilibria.;

JEL Classification: E21; E22; E32; E44; E63;

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Bibliographic Information

Provider: Federal Reserve Bank of St. Louis

Part of Series: Working Papers

Publication Date: 2017-02-22

Number: 2016-27

Pages: 44 pages