Question

Provide some intuition for the following statement: “The equilibrium real interest

rate is a measure of how plentiful the future is expected to be relative to the present.”

Answer 1

It shall be noted that the real interest rate plays the role of the price here. The real rate adjusts so as to bring quantity demanded equal to the quantity supplied.

When current income increases, households would like to increase their consumption, but by less than the change in current income. Put differently, they would like to save some of the change in current income. In equilibrium, market-clearing dictates that consumption rise one-for-one with income, however. In order to make households willing to increase their consumption one-for-one with the change in income, the real interest rate has to fall. The household would like to increase its saving, but the real interest rate must fall to dissuade them from increasing their saving since in equilibrium all output must be consumed.

Thus, the real interest rate adjusts to equate the current demand for goods with the current supply of goods. Because consumption is forward-looking, in equilibrium the real interest rate ends up being a measure of how plentiful the future is relative to the present. If current income is high relative to the future, the household would like to save to smooth out its income; this is not possible, so the interest rate must fall to dissuade the household from doing this saving