THE INTEREST‐INDUCED WEALTH EFFECT AND THE BEHAVIOR OF REAL AND NOMINAL INTEREST RATES: A COMMENT

Abstract

IN A RECENT ARTICLE published in this Journal Burton Zwick [6] investigates the implications of the interest-induced wealth effect for the response of interest rates to monetary change and to changes in the expected inflation rate. He argues that the introduction of the interest-induced wealth effect into an otherwise conventional macroeconomic model can explain the complete snap-back of interest rates to their original level after a monetary change but prior to a complete adjustment of the price level and the delay in the response of nominal interest rates to a change in the expected inflation rate. He also explores the implications of the interestinduced wealth effect for the existence of neutrality and the dynamic adjustment of interest rates to monetary change at full employment. Zwick's analysis of the interest induced wealth effect is flawed in three ways: (1) He incorrectly integrates the interest-induced wealth effect into his IS-LM framework. (2) Although Zwick's model with wealth effects includes both price and interest-induced wealth effects, Zwick ignores the implications of the price-induced wealth effect. Therefore, his comparative static results for increases in the money supply and the expected inflation rate are inconsistent with the model he presents; and (3) Zwick misspecifies his wealth variable. He assumes that the nominal value of real assets is unaffected by changes in the price level and that the valuation of real assets is affected by nominal rather than real interest rates. In Section I we will correct the specification of the wealth variable, demonstrate the way the interest-induced wealth effect affects the IS curve, and set out the cases that must be compared to determine the implications of the interest-induced wealth effect. In the remaining sections of the paper we assess the implications of the interest-induced wealth effect for the response of real and nominal rates to changes in the money supply and to changes in the expected inflation rate.