In a recent engagement with fellow economists on the role of monetary policy in boosting economic growth, a colleague advanced the familiar argument that the rate of return on capital (r) is greater than economic growth (g) and lamented that the Reserve Bank has kept policy rates way too high and made it too costly to fund investment. The argument then follows that the Bank must depress long-term interest rates to reduce the cost of funding for the state and investors. But this reasoning misses the most basic economic principles.

At its basic level the cost of capital (r) is determined by supply and demand for that capital in the economy, which includes global capital markets. As long as an economy does not accumulate savings, in other words it is a net borrower, the cost of capital will remain high. Scarcity drives the price of resources higher. This brings the natural equilibrium within the Solow growth model, where the cost of capital will always be greater than economic ...

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