lecture 12

Question 1

Why can’t nominal interest rates fall far below zero?

Answer 1

• If negative interest rates are paid on savings, househoulds could always hold money instead, because it yields at least zero interest.
• banks are doing the equivalent: holding their reserves at the ECB rather than lending to the private sector, which is risky.

Question 2

Why is it a problem that there is a zero-lower bound (ZLB?)

Answer 2

• there are situations where the nominal interest rate should be negative to stabilize the aggregate economy
• after the economic and financial crisis since 2008, output and, by now, also inflation have been below their target values.
• estimated interest rate rules indicate that policy interest rates below zero would have been the right response.

Question 3

What creates the need for negative real interest rates?

Answer 3

• before the crisis, private household debt has increased and banks have accumulated large amounts of bad loans.
• now, after the crisis, households and banks “restore their balance sheets”: bringing debt back down to sustainable levels
• households raise savings and thus reduce consumption and banks do not give out new loans because of high perceived risks
• government budget cuss also lead to downward pressure on demand

Question 4

quantitative easing & its problems

unconventional monetary policy when dealing with the zero-lower bound

Answer 4

• expand the balance sheet of the central bank by buying long-term government bonds or privately issued corporate bonds.
• expands the amount of money in the economy
• aim: reduce long-term interest rates and stimulate investment

problems:
* banks may not use the reserves to make new loans, but hoard them
* bonds on the balance sheet of the central bank may be risky: the central bank may eventually make large losses
* it may not be able to take the reserves out of the economy when inflation picks up

Question 5

forward guidance & its problems

unconventional monetary policy when dealing with the zero-lower bound

Answer 5

• exploit the forward-looking nature of economic behavior in order to steer the economy
• promise higher inflation in the future.
• expecation of higher inflation is supposed to reduce real interest rates now, even when the nominal interest rate is at zero
• a reduced real interest rate today should stimulate demand

problems:
once the economy is out of the ZLB, why should the central bank create inflation? After all, it does not like inflation. So it is not clear whether monetary policy has an incentive to deliver on its promise and the public may not believe promises made today. the promise is not credible and thus may be ineffective.

Question 6

higher inflation target & its problems

long-term strategy to deal with the zero-lower bound

Answer 6

• many economists have proposed to raise the inflation target to create a buffer for monetary policy. Then even large negative shocks will not push interest rate to ZLB.
• suppose the annual inflation target would be at 4%

problems:
* economic actors may perceive this a s a broken of a low and stable inflation and question the central bank’s credibility
* this may lead to less stable inflation and higher inflation risk prima, raising long-term nominal interest rates
* in the transitition to a higher average inflation rate, those savers who hold long-term assets that were priced according to low inflation expectations would make losses. this may be a burden for pension funds and other investors.