The Lower Bound and Negative Interest Rates Flashcards
Interest rates and cash
When the interest rate is positive, cash is a strictly dominated asset. The return on bonds is positive, and the yield from cash is zero. Therefore, it makes financial sense to not hoard cash.
When the interest rate is negative, cash becomes more favourable, as a zero yield is better than a negative yield.
Rates can now be slightly negative, but there is a lower bound in the presence of cash.
What happens to the money demand curve when we hit the ELB?
It becomes flat, not negatively sloped, as no one wants to purchase bonds and people want to hold cash instead.
This leads to a liquidity trap.
Draw the three equation model with a zero lower bound.
Negative rates are not possible.
IS curve shifts inwards due to a severe demand shock. Inflation expectations fall significantly, and the Philips curve shifts outwards. CB targets desired output gap.
Fisher equation means the minimum real rate is the minimum policy rate - inflation rate.
Desired interest rate is very low, but this is unattainable, along with the stabilising rate. Conventional monetary policy can only prevent the inflation rate from falling further. This leads to further falls in inflation, even when the real rate is zero.
Taylor Rule and Negative rates
When the effective lower bound is hit, the Taylor rule can no longer be used to set policy rates. This is because, at the lower bound, conventional monetary policy is ineffective.
Negative Rates
If the Bank rate was minus -0.1%, then a £1000 deposit would be worth £999.
Policymakers would not expect all rates to be negative, merely for this lower rate to be transferred throughout the economy.
Are Negative Policy rates effective?
- Limited impact on household deposit rates, but corporate rates appear to be more affected by them.
- This may stimulate corporate spending, which may boost growth and unemployment.
- Financial markets appear unimpeded under negative rates.
How do negative interest rates affect the money demand curve?
It retains its negative slope, with increases in the money supply being absorbed.
Gesell Tax
Tax on Cash.
Acts like a negative interest rate on returns. Keeps the money demand curve negatively sloped.
Shadow Rate
A measure of how conventional and unconventional monetary policy works.
Gives us an idea of how effective unconventional monetary policy has been.
Symmetry
Lack of symmetry in how we can set policy rate.
Lots of scope to raise rates, but much less scope to cut them bc of the ELB.
