88th International Atlantic Economic Conference
October 17 - 20, 2019 | Miami, USA

Interest rate bands of inaction and play-hysteresis in domestic investment: Evidence for the Euro area

Friday, 18 October 2019: 10:00 AM
Ansgar Belke, Prof. Dr. , WiWi, University of Duisburg–Essen, Essen, Germany
Coletta Frenzel Baudisch, Ph.D. , Deutsche Bundesbank, Frankfurt, Germany
Matthias Göcke, Ph.D. , University of Duisburg–Essen, Giessen, Germany
The interest rate represents an important monetary policy tool to steer investment in order to reach price stability. Therefore, implications of the exact form and magnitude of the interest rate-investment nexus for the European Central Bank's effectiveness in a low interest rate environment gain center stage.

We first present a theoretical framework of the hysteretic impact of changes in the interest rate on macroeconomic investment under certainty and under uncertainty to investigate whether uncertainty over future interest rates in the Euro area hampers monetary policy transmission. In this non-linear model, strong reactions in investment activity occur as soon as changes of the interest rate exceed a zone of inaction, that we call a 'play' area.

Second, we apply an algorithm describing path-dependent play-hysteresis to estimate investment hysteresis using data on domestic investment and interest rates on corporate loans for five Euro area member countries for 2001Q1 to 2018Q1. We find hysteretic effects of interest rate changes on investment in most countries. However, their shape and magnitude differ widely across countries which poses a challenge for a unifed monetary policy. By introducing uncertainty into the regressions, the results do not change much which may be due to the interest rate implicitly incorporating uncertainty effects in investment decisions, e.g. by risk premia.

Hence, the existence of "bands of inaction" in domestic investment in several Euro area countries should not be neglected by central banks. This result suggests that not every decrease of the interest rate entails additional investment activity. However, a large decrease of the interest rate implies passing the border of a play (inaction) area, resulting in a strong reaction of investment. In addition, we show that the play area is path-dependent and moves its position with strong interest rate movements. Therefore, no unique exit and entry triggers of the interest rate exist.

These new findings have important implications for the monetary policy transmission process in the Euro area. First, changes in interest rates affect investment demand in a non-linear way. The magnitude of a necessary monetary stimulus depends on the historical time-path of the variables. Second, the shape and the effect of a change in interest rates are heterogeneous, i.e. member country-specific. Third, any stepwise exit from zero interest rates by the ECB (interest rate reversal) will not do great harm to investment demand in the Euro area because the Euro area finds itself within a play area.