Abstract
Abstract A decrease in interest rate in traditional view of monetary policy transmission is linked to a lower cost of borrowing which eventually results into a greater spending in investment and a bigger GDP. However, a decrease in interest rate is also linked to a decrease in interest income which, in turn, affects the aggregate demand and total GDP. So far, no concerted effort has been made to investigate this positive inter-relation between interest income and GDP in the existing literature. Here in the first place we intuitively describe the inter-relation between interest income and output and then provide a micro-foundation of our intuitive reasoning in the context of a small endowment economy with finitely-lived identical households. Then we try to uncover the impact of nominal interest income on the macroeconomy using multiplier theory for a panel of some 04 (four) OECD countries. We define and calculate the corresponding multiplier values algebraically and then we empirically measure them using impulse response analysis under structural panel VAR framework. Large, consistent and positive values of the cumulative multipliers indicate a stable positive relationship between nominal interest income and output. Moreover, variance decomposition of GDP shows that a significant portion of the variance in GDP is attributed to interest income under VAR/VECM framework. Finally, we have shown how and where our analysis fits into the existing body of knowledge.
Highlights
In the existing literature, nominal interest expense is usually considered as a cost of production (See for example, Hicks (1979))
A decrease in interest rate in traditional view of monetary policy transmission is linked to a lower cost of borrowing which eventually results into a greater spending in investment and a bigger Gross Domestic Product (GDP)
Variance decomposition of GDP shows that a signi cant portion of the variance in GDP is attributed to interest income under VAR/Vector Error Correction Model (VECM) framework
Summary
Nominal interest expense is usually considered as a cost of production (See for example, Hicks (1979)). When we di erentiate the above expression with respect to Yk we take rp as constant This is due to the fact that periodic endowment and interest rate are assumed to be exogenously determined and are independent of each other. When we di erentiate the above expression with respect to rk we can take rp as constant as long as p ≠ k using the fact that the interest rates at di erent time periods are exogenously determined and are independent of each other. In our representative economy: GDPp = Cp + GSp where GDPp , Cp and GSp are the output, consumption and savings at period p in our representative economy Di erentiating both sides of the above equation with respect to interest income Ip we get: dGDPp dIp dGSp dIp (29). D is used to appropriately discount the future responses
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