What is “mean reversion” in interest rates and how is it related the interest elasticity of...

What is “mean reversion” in interest rates and how is it related the interest elasticity of investment demand?

Expert Solution

Mean reversion in the interest rate, refers to the phenomenon that shows that interest rates move back to the mean value even if the interest rates are varied in the short run on the basis of economic conditions. So, there is a tendency in the interest rate movement that drives it towards the mean value. The mean reversion phenomenon causes change in interest rates towards the mean and it affects the investment demand with the change in interest rate. So, investment demand will be back to its stable value of the long run that is based on a mean interest rate. Here, the flatness or the steepness of the investment & saving (IS) curve, decides the nature of elasticity in the investment demand on the basis of change in interest rate. But, it will always move towards the mean investment demand at mean interest rate. Therefore, the tendency of mean reversion in the interest rate, makes investment to be long term planning that can be affected in the short run, but moves back to its original planned value.

Rahul Sunny answered 2 years ago

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