Working Paper: NBER ID: w22196
Authors: Robert E. Hall
Abstract: Over the past few decades, worldwide real interest rates have trended downward. The real interest rate describes the terms of trade between risk-tolerant and risk-averse investors. Debt pays off equally across contingencies at a given future date, so debt is valuable to risk-averse investors to smooth consumption across those contingencies. In an equilibrium with trade between investors who differ in attitudes toward risk, the risk-tolerant investors borrow from the risk-averse ones, shifting the risk to those whose preferences favor taking on risk. Heterogeneity in risk aversion takes two forms in the model of the paper: variation in coefficients of relative risk aversion and variation in beliefs about the probabilities of seriously adverse outcomes. If the composition of wealth shifts into the hands of investors with higher coefficients of relative risk aversion and investors who believe in higher probabilities of bad events, the real interest rate falls. The paper calculates likely magnitudes of the decline and presents evidence in favor of a shift in the composition of wealth toward the holdings of the more risk-averse. In particular, the United States absorbs large amounts of risk by borrowing from more risk-averse countries, notably China, which thereby shed corresponding amounts of risk.
Keywords: real interest rate; risk aversion; wealth distribution
JEL Codes: E43; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| increase in the proportion of risk-averse investors (G40) | decrease in the safe real interest rate (E43) |
| growth of risk-averse wealth (D11) | decrease in the safe real interest rate (E43) |
| risk-averse investors stabilize consumption through safe debt (G51) | decrease in the safe real interest rate (E43) |
| shift in the composition of wealth toward more risk-averse investors (G11) | decline in the safe real interest rate (E43) |