What, then, do they affect, and why would people think they did affect the cost of capital? I think it works like this. Changes to the policy rate affect the equilibrium level of the money stock that is compatible with the (ex hypothesi fixed) real-terms cost of capital. The quantity of money, and hence the volume of lending, expand in response to an interest rate cut. Notionally we can imagine that the cost of capital would fall as Bank Rate fell, except that borrowing expands in response, bidding up the cost of capital back to its fixed real-terms level.
If we imagine this as a process taking time and (against my better instincts and normal habit) accept a description of the economy as sometimes being ‘out of equilibrium’, then when we are ‘out-of-equilibrium’ here, money is available at below the cost of capital (or, we could say, the cost of capital is below its equilibrium level). And of course whether the process is instant or drawn out, the expansion in the money stock will be associated with additional investment in the short term.
But it is important to observe that the economy can return to equilibrium (the cost of capital can revert to its fixed level) but with a higher money stock and a lower policy rate. So we could, for example, have a 0.5 percent interest rate and a 7 per cent cost of capital. What will happen then? Well, some contracts might be written normed to the Bank Rate (they might be ‘variable rate’ borrowing agreements). They might, for example, say the interest paid will be Bank Rate plus 6.5 per cent. If the market were confident that Bank Rate would stay at 0.5 per cent throughout the lifetime of a loan, that might be how such an agreement were written (though it is more likely to shade below 6.5 per cent reflecting the fact that the risk of rates rising is rather higher than of them falling – so perhaps it would say ‘Bank Rate plus 5.5 per cent’). By contrast, if the market expected rates to rise soon, then the margins above Bank Rate in variable-rate contracts would be much lower — e.g. they might only say ‘Bank Rate plus 4 per cent’.
A consequence will be that the more embedded becomes the market’s view of very low rates being sustained over time, the greater the consequences of raising Bank Rate, because the higher interest rates for variable-rate contracts would rise. If variable-rate contracts are Bank Rate plus 4 per cent and rates go from 0.5 to 2 per cent, the interest rate charged rises from 4.5 to 6 per cent. But if they are Bank Rate plus 6 per cent, the rate rise is from 6.5 to 8 per cent.
Of course, changes to the money stock will affect the price level (the inflation rate) and thus affect the value of past investments – higher inflation will tend to mean that the cost of servicing past borrowing falls, but that is a different matter from reducing the cost of new investment. If anything, reducing the cost of past investment will tend to increase the cost of new investment, as lenders will want extra compensation for inflation risk.
Let’s emphasise again: keeping the Bank Rate at 0.5 per cent over the medium-term will not (in the direct sense one might naively expect) change the real-terms cost of capital for investors. A very low Bank Rate will not encourage additional medium-term investment growth. Instead it changes the money stock, at best encouraging additional short-term investment (though even this is not unambiguous). But it will mean that the borrower risks in variable-rate contracts become higher – deterring investment in the medium-term. It is simply an error to imagine that the economy will grow at its fastest, over the medium-term, if interest rates are kept far below their natural rate.