Is This Decision Right?

Yesterday Bank of Japan (BOJ) decided to raise the interest rate which has been harshly discussed among economists in Japan.

What we have to concern most about this policy decision is what effect it has on the economy. This is a very important question which remains to be unsolved, but there is a big disagreement among economists.

Economics has many unsolved problems which some people may think as fundamental economic questions that should have been solved by economists. This is one of them.

The Yomiuri Shimbun (Feb. 22, 2007)
The Bank of Japan's Policy Board decided Wednesday to raise the key interest rate by a quarter point, to 0.5 percent per annum, marking the first rate hike in about seven months since the central bank discontinued its zero-rate policy in July last year.

The Policy Board approved 8 to 1 Gov. Toshihiko Fukui's proposal to raise the unsecured overnight call rate, which is a primary target for the central bank's guiding of short-term interest rates, in a majority vote at its meeting. Among the board members, only Deputy Gov. Kazumasa Iwata voted against raising the rate. It is rare to see a split vote among the three central bank executives on the board.

The key rate is now 0.5 percent per annum for the first time in 8-1/2 years, since September 1998.

.....They judged that consumer spending and price levels--which had been seen as detracting from the likelihood of a rate hike--would basically improve in the mid-to long terms. At the previous meeting in January, the central bank's policy-setting board did not raise the key rate. Fukui said at the time: "There are various economic indicators, some are positive and others are negative. Thus we need to closely watch the trend for the time being."

A number of economic indicators released since the January meeting were seen as making a rate hike less likely, including the slowing in the rate of increase of the consumer price index and a slowdown in the pace of wage increases. Many financial market players believed the economic data would not be enough to persuade the central bank to raise rates at this time.

We have mainly two macroeconomic views on the effects of high rates on the economy:

(1) Keynesian macroeconomic theory tells that high rates will generally put a downward pressure on consumer spending and investment expenditure. So high rates would be bad news to us because it imposes the interest burdens on our social life.

(2) Real-Business-Cycle theory,in contrast, tells that high rates will do nothing to us. The interest rates we are now taking up here are not real but nominal rates, that is, those unadjusted for inflation rate in the economy. According to this theory, only real interest rate influences our economic activities; High real rate decreases our today's consumption expenditure because it now becomes more costly relative to our future's consumption. And it makes us work harder because what we earn now has higher value in the future, that is, we can get the higher rate of return on saving. In sum high rates would be good news to us because we can enjoy more goods and services later. However, in this case, "nominal" high rates wouldn't do any effect on the economy.

Which view do you support? I feel Keynesian is natural, but I'm not sure for the reason. Later I'll talk to you about it.