Monetary Policy- Interest Rates Flashcards
Describe real and nominal interest rates across the world
Real interest rates are low globally.
The downward trend began in the 1990s, with many countries experiencing slightly negative rates since mid-2010s.
What do low-interest rates imply for policymakers?
Low rates imply limited scope for central bankers, and thus a reliance on unconventional monetary policy.
Prior to the financial crisis, strongly positive rates meant central banks had the scope to cut rates and not rely on unconventional monetary policy.
What are fundamentals and how do they determine interest rates?
Fundamentals are the underlying structural factors determining the long term interest rates.
Equilibrium interest rate is where desired wealth = desired capital schedule.
An ageing population has caused the desired wealth schedule to shift outwards.
Low international productivity has caused the desired capital schedule to shift inwards.
This combines, along with uncertainty, to shift the long term real rates downwards.
What does low inflation imply for real and nominal interest rates?
Near-zero inflation implies a very close relationship between real and nominal rates.
This is because of the fisher equation:
r= i - last periods inflation.
Low-interest rate implications for monetary policy
- Less scope to cut rates following recessions. This is their most important tool.
- Once the yield curve is flattened, there is little more monetary policy can do.
- Low yields imply high asset prices, so greater scope to fall.
- Low yields prompt search for higher yields, leading to risk-taking behaviour.
Low-interest rate implications for fiscal policy
r= nominal interest rate g= GDP growth rate
g > r, not r > g in the era of low-interest rates.
The g and r gap in the UK is 4.5% on average over 50 years.
Implications of g > r
It means that debt as a proportion of GDP will fall over time.
debt/gdp = (r- g)(debt/gdp) last period- primary balance/GDP.
If r < g, then this will be a negative number. This implies the existing debt stock will fall.
(unless gov has new lending).
Furman and Summers on GDP
They contend it is the discounted sum of GDP over the future is what’s relevant, not GDP. This is because Debt to GDP is a stock-flow relationship.
If the discount rate is lower than the GDP growth rate, then the debt will shrink towards zero. UNLESS investors demand higher interest rates to hold the debt.
Stock-Stock and Flow-Flow Measures of GDP
Stock-Stock measure:
Debt over the discounted value of GDP shows that the debt is stable relative to future GDP.
Flow-flow measure: Real debt service costs have fallen even while debt has increased.
In the UK, the government can now borrow at -2% over 40 years.
