Question

Explain using words why, under Wicksell’s Theory, an increase in the money supply has no long term effect on interest rates or the levels of savings and investment in the economy. List at least 6 fundamental changes in the economy which might alter the neutral rate.

Answer 1

The neutral interest rate is the long run interest rate; were the economy is in full employment and stable inflation. The neutral interest rate is measured in real terms. This rate is determined by the eagerness of the firms to invest and eagerness of the consumers to save. This determines how much the consumer consumes in future and the amount that didn’t save for the future. The most important fundamental changes that alter the neutral rate of interest are:
The household savings and borrowing will increase.
Immediate repayment of the loans to build up positive net wealth
Increasing rate of consumption.
Bank deposits and bonds will provide reliable returns on interest income.
Attain high price stability in current economic condition.
Expected inflation increased.
High level of investment at present.
Increase in the labour force with respect to the rise in population.