Question

The interest rate affects the investment patterns in the economy. A friend of yours suggests a get-rich-quick scheme: Borrow from the nation with the lower nominal interest rate, invest in the nation with the higher nominal interest rate, and profit from the interest-rate differential. Do you see any potential problems with this idea? Explain. What are the cons of the strategy?

Consumer spending during holiday seasons affects the aggregate demand (AD) in the economy. AD drastically declines during serious recessions. In 1939, with the U.S. economy not yet fully recovered from the Great Depression, President Roosevelt proclaimed that Thanksgiving would fall a week earlier than usual so that the shopping period before Christmas would be longer. Explain what President Roosevelt might have been trying to achieve, using the model of aggregate demand and aggregate supply. Was the policy effective to increase AD?

Answer 1

(1) The investment strategy of borrowing at low-interest and investing at high-interest is an instance of arbitrage. However, this strategy cannot be effective for a long period because, as more and more investors see the profit potential of this strategy, higher number of investors will start to borrow funds from the low interest country, which will increase its investment demand, shift the investment demand curve rightward and increase interest rate. This will continue until interest rate in the lower-interest rate country increases to the point of the higher-interest country's interest rate, and profit opportunities are eliminated.

(2) Roosevelt wanted to boost consumption demand in order to increase aggregate demand. Higher aggregate demand would shift the AD curve rightward, increasing both price level and real GDP. In following graph, long-run equilibrium is at point A where AD, short run aggregate supply (SRAS0) and long run aggregate supply (LRAS0) intersect, with price level P0 and real GDP (= potential GDP) Y0. During recession, AD was lower at AD1, intersecting SRAS0 at point B with lower price level P1 and lower real GDP Y1, creating a recessionary gap equal to (Y0 - Y1). Roosevelt wanted to increase aggregate demand so as to shift AD1 rightward as closest as possible to AD0. However, since consumers were uncertain about future income and state of economy, so consumer confidence was low and peole did not increase their personal consumption by a large magnitude. Therefore, the Roosevelt policy was not fully effective.