Working Paper: NBER ID: w16741
Authors: Robert E. Hall
Abstract: In a market-clearing economy, declines in demand from one sector do not cause large declines in aggregatge output because other sectors expand. The key price mediating the response is the interest rate. A decline in the rate stimulates all categories of spending. But in a low-inflation economy, the room for a decline in the rate is small, because of the notorious lower limit of zero on the nominal interest rate. In the Great Depression, substantial deflation caused the real interest rate to reach high levels. In the Great Slump that began at the end of 2007, low inflation resulted in an only slightly negative real rate when full employment called for a much lower real rate because of declines in demand. Fortunately the inflation rate hardly responded to conditions in product and labor markets, else deflation might have occurred, with an even higher real interest rate. I concentrate on three closely related sources of declines in demand: the buildup of excess stocks of housing and consumer durables, the corresponding expansion of consumer debt that financed the buildup, and financial frictions that resulted from the decline in real-estate prices.
Keywords: economic slump; financial crisis; interest rates; consumer debt; employment
JEL Codes: E1; E2; E3; E4; E5
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Decline in demand from one sector (R22) | Adjustments in other sectors (F29) |
| Adjustments in other sectors (F29) | Prevent large declines in aggregate output (E23) |
| Decline in demand from one sector (R22) | Interest rates (E43) |
| Interest rates (E43) | Stimulate spending across sectors (E20) |
| Excess stocks and consumer debt (E21) | Financial frictions (G19) |
| Financial frictions (G19) | Overall spending (H59) |
| Financial crises (G01) | Ability to lower interest rates (E43) |
| Ability to lower interest rates (E43) | Prolonged unemployment (J64) |