Real Interest Rates & Behavioral Finance

There is a topic in behavioral finance that addresses the economic memory of a population. Much like any other life instruction, the leaders of the family unit pass own their knowledge and experience to the younger generation. It seems that economic lessons in particular are etched deeply into the minds of the young and take precedence over the the economic scenario that the younger generation is met with.

For example, some raised by the generation that lived through the Great Depression misplayed the 1970s. Saving during a time of high inflation is a mistake. Debt is actually a good idea because inflation decreases the real interest rate that a borrower pays over time. Their utility was maximized by spending earlier than they were taught, despite high nominal interest rates.

We may be in the midst of a reversal. If we do wander into a deflationary period, borrowing would not be the preferred behavior. A borrower would be paying interest to buy goods in the present period when the same goods will be selling at a lower price in a subsequent period. High real interest rates benefit lenders.

This is a complex and difficult problem to resolve since business owners are discouraged from borrowing as well. Why would they borrow money to produce a good when, by the time production is completed, the sales price of the good decreases. Japan has been battling this problem for almost 20 years.