Understanding the Decline in the Safe Real Interest Rate

Robert E. Hall

NBER Working Paper No. 22196
Issued in April 2016
 

Over the past few decades, worldwide real interest rates have trended downward. The real interest rate describes the terms of trade between risk-tolerant and risk-averse investors. Debt pays off equally across contingencies at a given future date, so debt is valuable to risk-averse investors to smooth consumption across those contingencies. In an equilibrium with trade between investors who differ in attitudes toward risk, the risk-tolerant investors will borrow from the risk-averse ones, shifting the risk to those whose preferences favor taking on risk. In the case where investors have preferences that are additively separable in future states and in time, attitudes toward risk are heterogeneous among investors if they differ in the curvature of their utility kernels and differ in their beliefs about the probabilities of outcomes, especially adverse outcomes. If the composition of investors shifts toward those with higher curvature (higher coefficients of relative risk aversion) and toward investors who believe in higher probabilities of bad events, the real interest rate falls. The paper calculates likely magnitudes of the decline and presents evidence in favor of a shift in the composition of investors toward the more risk-averse. The downward trend in real interest rates is a significant problem for monetary policy but is helpful to heavily indebted countries.