Interest Rates and Total Spending

Abstract

Macroeconomic theories generally accord the interest rate some influence on the total volume of spending and so on production, employment, and price levels. But when we examine this influence, we run into some paradoxical contradictions. On the one hand, a low interest rate is supposed to stimulate investment while possibly, though less surely, discouraging saving in favor of consumption; a high interest rate is supposed to have opposite effects.' On the other hand, the interest rate measures the opportunity cost of holding a cash balance by way of interest earnings sacrificed. The lower this cost, the more cash a typical firm or individual is likely to decide to hold at any given level of income or transactions. The higher the interest rate, the smaller are the cash balances demanded relative to income or transactions. In short, a low interest rate tends to slow down and a high interest rate to speed up the income and transactions velocities of money.2 According to the saving-and-investment approach, then, a low interest rate stimulates and a high interest rate restrains the total flow of spending. But according to the velocity-of-money approach, a low interest rate restrains spending and a high interest rate stimulates it. A slightly different way of looking at the matter underlines the paradox. Simple mental experiments show that a low interest rate increases the attractive-