A Behavioral Theory of Interest Rate Formation (Classic Reprint)

A Behavioral Theory of Interest Rate Formation (Classic Reprint)

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Excerpt from A Behavioral Theory of Interest Rate Formation

This paper developes and marshals empirical support for a theory of the nominal, short-term, risk-free interest rate. Unlike most approaches to the problem, the formulation presented here does not assume equality of supply and demand for securities. Rather, the formulation is a mechanism which would help to bring supply and demand into balance in a larger macroeconomic model. Empirical support is offered at two levels of aggregation: Empirical studies of individual human decision making are used to suggest an appropriate structure; the structure is then estimated using macro-economic data.

In the proposed formulation the risk free interest rate moves in response to liquidity pressures experienced principally by intermediaries. Liquidity pressures cause movements in the interest rate relative to the "underlying interest rate," a construct which represents the interest rate environment to which people have become accustomed.

The formulation has grown from work on the M. I. T. System Dynamics National Model (for a description of the modeling project see Forrester 1984 and 1979). The National Model is a simulation model of an industrial economy. It possesses two production sectors, a household sector, a financial sector, and a government sector. The Model is intended to aid in understanding the major behavior modes of industrialized economies including the business cycle, the Kuznets cycle, the economic long wave, inflation and deflation, and economic growth. (For discussion of the several major economic behavior modes see Schumpeter 1944; Volker 1978; and Forrester 1976, 1982).

In some respects the National Model represents a departure from prior economic modeling. The nature of this departure gives rise to the need for a new interest rate formulation. Three characteristics are particularly important in this regard. First, the National Model does not permit exogenous time-dependent inputs; consequently, exogenous interest rates could not be used as explanatory variables in the interest rate formulation. Using exogneous interest rates begs the question of how interest rates are formed.

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