Neoclassical Story of the Monetary Policy Transmission Mechanism
The traditional orthodox story tells us that interest rates affect the economy through a number of channels including (i) the investment channel whereby higher interest rates reduce investment, as it becomes more costly to invest thereby inducing firms to either invest with retained earnings or forego investment because expected profits will be too low at higher interest rates (ii) the consumption channel, which is similar to the investment channel, in that higher interest rates make borrowing more expensive and so higher rates mean consumers cut back on big-ticket items such as houses, cars and white-goods; furthermore higher rates not only make borrowing plans more expensive, but also make actual borrowing more expensive: those with loans already will face higher payments and may thus cut-back elsewhere (iii) the wealth effect stems from the effect of rates on asset prices; higher interest rates mean investors can get higher rates from putting their savings in bank accounts rather than in the stock market (and other financial assets) and so demand for assets falls causing a fall in their price (pushing up the return on that investment) which leads to a negative wealth effect as asset prices fall (iv) finally we consider the export effect, whereby a higher interest rate increases demand for a domestic currency (hot money flows in to take advantage of the higher rate) causing an appreciation which leads to fewer exports and hence lower aggregate demand.
There are many other proposed channels, but these are arguably the most important, and regardless the general story is that higher interest rates negatively affect a component of aggregate demand. To reiterate this point – the neoclassical story is that higher interest rates lower aggregate demand; therefore if a policymaker wanted to increase aggregate demand – say in times of economic recession – then they can use monetary policy to reduce interest rates which will stimulate aggregate demand and increase output. This article is concerned not with how such monetary policy is used, but whether it is effective at the so called zero lower bound, and whether interest rates can, and should, go negative to boost the economy.
Since the 2008 Financial Crisis central banks across the world have been reducing interest rates close to zero in order to stimulate the economy through the mechanisms above. Whilst this might have ameliorated some of the economic recession, it hasn’t been successful in boosting economic growth and returning economies to significant growth. Some have taken to calling for Keynesian measures as an alternative to the arguably failed monetary policies, regardless of what policy should be subscribed the question of why interest rates haven’t been working still needs to be answered. Ultimately, it was believed that interest rates failed to stimulate the economy sufficiently because they weren’t low enough, but couldn’t fall lower due to what is known as the zero lower bound (ZLB) or the “liquidity trap”.
The Zero Lower Bound
Prior to the Financial Crisis economists believed that nominal interest rates (the rate which is advertised) couldn’t fall below zero. They reasoned that if nominal rates fell below 0 then people simply wouldn’t save/hold assets – they’d keep all their money in the form of cash, which has a nominal return of 0. Yet in recent years we have seen cases of central banks adopting negative rates in Switzerland, Denmark and the Netherlands, to name a few countries. This suggests that rates can fall below zero, for reasons discussed below. Beforehand, we note that just because nominal interest rates aren’t supposed to enter negative territory, it doesn’t mean that real rates can’t. The real interest rate equals the nominal rate minus inflation (r = i-π) so even when i=0 (assuming i=>0) r can be negative so long as inflation is positive. This is where the name “zero lower bound” comes from: when i=0 r=-π which is the zero lower bound. This suggests that even central bankers who believed i can’t fall negative can still affect the real interest rate by increasing inflation: higher inflation means lower rates which should hopefully mean more investment (where investment is believed to be a function of the real interest rate, and not the nominal rate).
If interest rates can’t go below this level then it suggests that there is a limit to the efficacy of monetary policy, and that aggregate demand could end up depressed with monetary policy not working (suggesting fiscal policy would be appropriate). At this point the aggregate demand curve would be flat (horizontal) at r=-π.
Nominal rates can fall below zero for a few reasons:
- The cost of holding money may be greater than zero in which case interest rates can be negative to this degree. For example, suppose the cost of holding money was x then it would make sense to keep your money in an interest-bearing account so long as the return was no less than x (the cost of holding the money itself). Costs can be incurred on holding large amounts of cash as a warehouse would need to be purchased, security installed and hired and insurance taken out.
- Exchange rate differences
“JPMorgan suggests that central banks now have the theoretical capacity to lower interest rates to minus 1.3 per cent in the US, minus 2.7 per cent in the UK, minus 3.45 per cent in Japan and as low as minus 4.5 per cent in the eurozone, highlighting that there was no evidence of the initial experiments triggering a rush for physical cash.”[*]
How can we overcome the zero lower bound?
Andy Haldane has suggested that one way central bankers can overcome the issue of the ZLB is by eliminating cash and relying on digital money. This way individuals have no alternative but to save any money they don’t spend in a savings account (or other assets, which would lead to a wealth effect) and hence face negative interest rates. Hence not only would this solution supposedly eliminate the issue of the ZLB but it would also reduce criminal activity by making it harder for them to hide their financial activity. However it might have societal issues, such as old people not being computer-literate and not being able to use digital cash as easily as paper cash.
Buiter proposes 3 methods for “eliminating the zero lower bound” which are (1) the abolition of currency, as proposed above, (2) paying negative interest on currency by taxing currency and (3) decoupling the numeraire from the currency of exchange. We shan’t discuss the third one due to its complexity, but in essence this solution proposes creating a new currency which will circulate in the economy (and be used as a means of exchange), destroying all notes of the old currency in circulation but maintain this currency as the official medium of account (i.e. all government contracts will be written using the old currency and any taxes will be recorded in the old currency, but both will be paid using the new currency) and then having an exchange rate between the old and new currencies, such that there is a negative interest rate.
Expanding on the second proposal (taxing currency) Buiter points out that there are issues in that currency is anonymous and doesn’t have to be claimed; if the government wanted to say that they will tax 5% of a given individual’s currency then they will have difficulty in enforcing this. To overcome this issue, the government could announce that any note serial number ending in a certain number will be destroyed (i.e. it won’t be redeemable to the central bank) which in a sense is a tax on currency. This could work, although the author points out that there may be credibility issues: if people still count this as legal tender then it will still exist, and then the government may have to use expensive policing measures to enact the policy. This proposal counts as a negative interest rate because taxing currency will reduce the money holdings of people, and will encourage them to spend this money thereby boosting AD.
An alternative to overcoming the ZLB is to set negative interest rates (more below), and Palley believes that one way this can be done is by charging commercial banks for their deposits with the central banks in the hope that this negative rate will then be passed on to consumers and thus have an effect in the economy.
Negative Interest Rates, the Keynesian Story
I’ve recently finished a paper by Thomas Palley on the failures of what he calls NIRP (negative interest rate policy), below is a brief summary of some of the points he, and others, make following a more Keynesian tradition. When reading papers I tend to highlight points of interest, in this paper I pretty much highlighted it all, so I would definitely recommend it to anyone interested in this area of theory and policy. An overview of the paper is that Palley believes that negative rates can have detrimental effects on aggregate demand and that negative rates as a policy can lead to a further accumulation of debt which exacerbates the issue which caused the Financial Crisis in the first place.
Firstly, Palley points out that the theory of the ZLB has been muddled. Current proponents claim that the ZLB occurs because interest rates can’t fall any lower (i.e. below zero), but the Keynesian argument behind this is not that they can’t necessarily fall any lower, but that investment and consumption spending has become insensitive to the interest rate. Under this story it doesn’t matter how low rates go investment and consumption won’t be affected by the interest rate. This makes intuitive sense – interest rates tend to be low when the economy is doing poorly because the central bank hopes that low rates will boost output; but if people expect the economy to be depressed for a long time period then they won’t borrow money to invest in additional capacity as they wouldn’t be able to make a return on this; no matter how cheaply they can borrow.
Secondly, as already mentioned, it is pointed out that when returns on a project hit zero (because there is no economic growth) then a firm will choose to spend any finance on “non-produced” assets, and not productive investment assets which lead to growth. These non-produced assets are “commodities like gold, patents and copyrights, and technical know-how and organizational capital embodied in existing firms acquired through mergers”. Basically, in economic downturns firms will spend finance on buying other companies or non-productive assets, such that negative rates do nothing to spur an increase in AD. Not only does this occur because future revenues look low, but also because low (/negative) interest rates today don’t necessarily imply low rates in the future, so a firm may not want to invest when they may “be saddled with future high interest costs”.
Thirdly, negative interest rates are supposed to make saving costly and so induce savers to start spending their money, providing a boost for the economy. Yet typically savers tend to have a target of savings in mind; a lower interest rate means they have to save more to reach such a target and hence could lead to the opposite intention: savings increase in the face of negative rates.
Importantly, Palley discusses the political economy implications of this – something which is forgotten in the mainstream – by pointing out that the wealthy are likely to have a diverse portfolio and be able to invest in risky assets, something the poor are not able to do. Hence negative rates on bonds and savings accounts will affect the poor more than the rich, which can have societal impacts. Moreover, it will have an economic impact as we would expect poorer people to have a higher marginal propensity to consume than richer people (Kalecki distributional effects).
Palley points out that low/negative rates affect the business model of insurance and pension funds, who invest money in assets in order to keep the insurance model going and to pay people’s pensions in the future. Lower rates could therefore reduce pension outlays (or increase costs) and mean insurers have to charge higher rates, effectively reducing disposable income in people’s pockets, which they can’t then spend on buying goods and services.
Finally, banks may refrain from passing on negative interest rates to savers as they wish to maintain their long-term relationship. They could choose to absorb the rates which would lower profitability and make the financial system more insecure, potentially leading to another credit crunch if banks lose trust in one another. Furthermore, lower profitability may lead to credit rationing which could result in profitable businesses or ideas not being able to gain finance. Instead, they could choose to pass on these costs to lenders rather than savers, which would lower demand for investment.
A separate point – not mentioned in this paper – is that interest rates act as a signal of what the central bank expects future inflation to be. A negative interest rate implies a deflationary expectation of inflation, and hence a rational consumer might realise this and decide to save more money for the future, when prices are expected to be lower (consumption deference).