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Does a Decrease in the Real Interest Rate Actually Stimulate Personal Consumption?

- An Empirical Study -

February 2000
Shinobu Nakagawa
Kazuo Oshima

Views expressed in Working Paper Series are those of authors and do not necessarily reflect those of the Bank of Japan or Research and Statistics Department.
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  1. As a remedy for Japan's distressed economy, Professor Paul Krugman of MIT has suggested that a reduction in real interest rates caused by inflation expectations would stimulate personal consumption. Although that is controversy whether inflation causing policy is effective or feasible, we must still ask whether a decrease in real interest rates actually stimulated personal consumption in Japan.
  2. Generally a decrease in real interest rates stimulates personal consumption, which is what Professor Krugman has pointed out. When the real interest rate goes down, in other words, the magnitude of the substitution effect, which stimulates consumption, outweighs that of the income effect, which reduces interest income. Scatter diagrams and estimation results of consumption functions show that negative relationships between the real interest rate and per capita consumption growth exist in the USA and UK, but there is no clear relationship in Japan.
  3. We find no clear relationship between the real interest rate and personal consumption because the Japanese people like to save and they don't want to consume by drawing on savings or by taking consumer loans even if real interest rates go down. In contrast, the use of consumer credit to buy durable goods is observed everywhere and every day in the USA and UK.
  4. There is also the fact that Japanese households have over 60 percent of safety assets such as deposits in savings and the older the household is, the larger this ratio is. Although consumption is stimulated by a decrease in real interest rates, it seems that at the same time and at the same scale interest income is reduced by that decrease, so that the substitution effect and income effect cancel each other out. Yet, in the USA and UK, the shares of safety assets are about 15 percent and 20 percent, respectively at the end of 1998, so the income effect in each country seems to be smaller than that of Japan.
  5. In conclusion, Professor Krugman's proposition that stimulating consumption by making the real interest rate decline makes sense in the USA and UK. Statistical evidence, however, shows that is not the case in Japan, because of the reluctance to use consumer credit in general and the likelihood that Japanese households will accumulate safety assets under any circumstances.