I got back from vacation and I thought it was time to write a short blog about a subject that caught my attention before my vacation after reading an article on it. Central banks of developed countries have lowered their interest rates to historically low levels in the last several years. The goal is to discourage saving money in a world that seems to be suffering from Secular Stagnation. But some economists – including myself – have been thinking about whether it is possible that lower interest rates might actually increase the savings rate. Could this really be the case?
The reasoning of central banks is logical. When I get my monthly income, I can either spend it now (on tea or something) or save it. The higher the interest rate, the more I am willing to save. However, when I want to buy a new car 5 years from now, I have to save less money in order to reach my desired amount of savings with a higher rate of interest:
Figure 1: Saving for a car
So, when people are saving with a target, then lowering interest rates might boost savings, which is clearly not the goal the central bank wants to achieve.
A more important example of targeted saving in western economies are pension schemes. The result of low interest rates has been that some pension funds had to increase their premiums to safeguard their long term liabilities. Saving for retirement is an important kind of saving in developed countries so perhaps targeted saving is the leading kind of saving. Saving for your retirement also takes a lot more time than saving for the car in my example, so the effect of lower interest rates is much larger for pensions. So it’s not so strange that some economist are thinking about whether lower interest rates might actually lead to slightly higher savings. If this is true, should central banks stop the bond buying programs and low rate policies?
When people want to save money, they have to acquire an asset. This can be a deposit account (claim on the bank) or a government bond. Especially pension funds are primarily investing their money in government bonds. So, if we assume that lower interest rates on these bonds (or higher prices) will lead to more demand for bonds, then we can look at what the current effects are of bond buying programs like QE.
QE in normal situation
When the ECB buys bonds in a normal situation this action leads to a lower interest rate on bonds:
Figure 2: Normal situation
The horizontal axis in figure 2 shows the amount of bonds which are available in the markets, the vertical axis is the interest rate and D and S are respectively the demand and supply curve. Notice that this is the normal situation, because investors are willing to buy more bonds (save more) as the interest rate gets higher. When the central banks buys bonds, the inelastic supply curve moves to the left, which leads to a lower interest rate. This is consistent with what we see in the real world now.
QE in targeted saving situation
When targeted saving is dominant, then a bond buying program of the central bank seems to lead to an increase in the interest rate:
Figure 3: Targeted saving situation
In figure 3 one can see what the effect of QE is in a world were lower interest rates might increase saving. In this situation QE seems to lead to higher interest rates. Because there are now fewer bonds in the market, the higher interest rate is needed to make supply and demand equal. Another way out would be if the shift to the left of the supply curve is accompanied by a downward shift of the demand curve, in that case the interest rate does not have to go up.
This is a strange outcome indeed and it is not at all consistent with the effect that bond purchases seem to have now. Perhaps other outcomes are possible when using a less simple model. But for now I will still assume – as most economists – that lower interest rates will have an upward effect on saving.
Summers (2016). The Age of Secular Stagnation, http://larrysummers.com/2016/02/17/the-age-of-secular-stagnation/
Fransman (2014). De trage zelfmoord van Europa, https://www.ftm.nl/artikelen/de-trage-zelfmoord-van-Europa
Daalder (2016). De centrale bank als spons, http://fd.nl/beurs/1160271/de-centrale-bank-als-spons
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