We know that a rise in real interest rates will cool down the economy in terms of investments. An increase in interest rate will provide higher incentive for saving rather than consumption. So people will start to save in banks and banks would be having a high stock of these savings. Now, effectively this stock should compel banks to lend more to the people needing it and hence it should drive down interest rates and raise investment levels. How is this fallacy arising ? Please explain


You are getting confused because you are "reasoning from a price change." Interest rate changes don't just happen by themselves, so they cannot be the cause of other effects in the economy.

What actually happens is:

  1. The central bank drains money from the economy.

  2. The interest rate has to rise, otherwise people would try to borrow more money than there is available.

The fact that other people can step in and become lenders may mean that the real interest rate wouldn't rise very much. But the central bank can take this into account. It can just drain extra money from the system to achieve its interest rate target.

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  • $\begingroup$ Is real rate not related to rate of inflation rather than these other people who would like to lend ? And if there are more people who are saving more in banks, what does banks do with these increased money deposited in their vaults ? Won't they try to lend it at a lower interest rate so that they can utilize these huge sums instead of just keeping them and paying interest on them ? I would be obliged if you could elaborate on this please . $\endgroup$ – Sub-Optimal Oct 12 '15 at 20:19
  • $\begingroup$ [deleted comment] $\endgroup$ – Tom P Oct 13 '15 at 2:23
  • $\begingroup$ Try drawing a simple supply and demand graph for some market, like oil. What happens when there is an increase in demand? The supply curve does not increase in response to to the higher price. No, the higher price already takes into account that supply is higher at a higher price. Similarly, the fact that people will deposit more money at a higher interest rate is already taken into account in determining the interest rate. It does not have any additional effect in response to the interest rate. $\endgroup$ – Tom P Oct 13 '15 at 2:41

The price and quantity of a scarce resource are determined by supply and demand. The quantity which would be offered at some imagined price increases with that price. The quantity which would be purchased at some given price decreases with price. The actual quantity and price of every transaction will then naturally be the level where the quantity offered equals the quantity demanded.

In the case of savings and investment, the price is the interest rate and the quantity is the amount lent and borrowed.

So there is no fallacy. The interest rate is the one agreed to when a lender (saver) and a borrower make a deal. The interest rate isn't the cause, it is the result of the agreement. The interest rate bid and offered at a given moment are two different numbers. There is no fallacy because there is no transaction. At the moment of transaction, there is a single number: the "interest rate" itself. So again, no fallacy.

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  • $\begingroup$ I don't completely follow you. How can interest rate be not the cause, interest rates are an important monetary policy that affect investments a lot. Could you please explain my question more specifically. $\endgroup$ – Sub-Optimal Oct 10 '15 at 11:41
  • $\begingroup$ Sorry, misunderstood the context of your question. You are speaking of the case where the central bank artificially increases interest rates, by selling Treasuries (and thus destroying private sector money.) When the Fed sells Treasuries, banks see reserve and capital ratios starting to fall. In response, they raise loan rates and otherwise restrict loans, and increase savings interest rates and otherwise try to attract funds. This happens just until the decline in reserves stops and the preferred level of risk/reward (capital and reserve ratios) of the bankers is restored. $\endgroup$ – Bob Oct 10 '15 at 21:52
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    $\begingroup$ BTW, this is just my guess, something to think about until we hear from someone who has studied economics. I've never taken a course in economics myself, so my thoughts are just the thoughts of a layman. I should also add that, even when interest rates change because of central bank policy, they are a result, not a cause. The Fed bids in the open market, as an equal, until the interest rates set by the market response are what they are targeting. $\endgroup$ – Bob Oct 10 '15 at 22:35

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