Economic variables respond differently to each stage of the cycle. Some are pro-cyclical, others are counter-cyclical, others are acyclical. The real interest rate is mainly counter-cyclical even if the timing of its movements does not completely overlap the cycle of economic activity. Nominal interest rates are instead pro-cyclical. Students can find evidence of this fact analysing real figures.
The reason of this behaviour has to be searched in the relationships between the interest rate, inflation and investment. Let's start from the trough of the cycle. To stimulate the economy the central bank allows the real interest rate to go down but in nominal terms, because of rising prices, the nominal interest rate increases. Eventually this policy will have the further effect of improving expectations, sustaining investment and aggregate demand. Growth will be restored and the economy will start an upward cycle. With growth also inflation will start rising, with an acceleration when the economy approaches the point of full capacity. At that stage authorities will start to use the monetary tool to decrease inflation. The real interest rate will rise and therefore investment will suffer. This will provoke a downturn in expectations with the nominal interest rate falling because of decreasing inflation but with the real rate still growing. Inflation will be brought under control at the cost of a new recession. Eventually we approach a new trough and start a new cycle.
Business decisions are strongly affected by the level of interest rates and economic activity.
i) Firms will need to analyse the past trend of different variables (economic activity, inflation, official discount rate, fiscal deficit) to understand the amplitude and length of the fluctuations and in which point of the cycle they are at the moment.
ii) using forecasting methods, they will try to predict future values of the real interest rate.
iii) if they forecast a reduction in the interest rate, they will be more willing to invest, because of expectations of higher sales, lower costs and greater profits. Since interest rates hardly overtake a certain threshold, much attention will be paid in understanding whether the economy is at the turning point, after which interest rates would start rising, profits declining and new investment more likely to be postponed.
Q1 Show how you would present a macroeconomic forecast of the economy (choose between the US, German, French or UK economies) to other business people. What use, if any, could a firm make of such a forecast?