Tag: interest rate

Those whom keep a close eye on monetary policy will realize that the real interest rate at the moment is positive. My data suggests it is above 1% mark right now given how the Overnight Policy Rate is at 3% and inflation is hovering around 2% with core inflation being slightly lower than headline inflation.

Despite an abstraction and not directly observed like the everyday nominal interest rate, it is the real interest rate that is crucial in determining decision between consumption and saving/investment in most cases. This is not to say the nominal interest rate is not an abstraction. It still is but real interest rate is not immediately understood or observed by laypersons as nominal interest rate.

The reason I am bringing up the issue about real interest rate is that I think there is a worry of a slowdown in the domestic economy, especially with European and Chinese economies showing signs of stress. And I am always not keen of shoring up the economy with fiscal policy in the traditional way as long as monetary policy can do the jobs well. I also think that monetary policy has done an excellent job in the past few years amid serious unprecedented crisis despite Keynesian’s liquidity trap theory, which appears to be irrelevant: as market monetarists have successfully argued, the fixation on interest rate is overrated in zero-interest rate situation. Market monetarists, the successor to the monetarism of the 1970s, of course, argue more about monetary policy but let us leave that aside for now because I know they would not like my fixation with interest rate here.

With more than 1% real interest rate, this creates the incentive to save more than to spend in the economy. Or to invest less. The bottom line is that it has a negative impact on economic growth.

One also has to remember that the OPR is the base rate. There are other rates based on the OPR and they are priced higher. This means the relevant real interest rate are higher than 1% for consumers and businesses.

Furthermore, in the free (or rather, maybe, just efficient?) market, I would assume the optimal real interest rate is 0%. This suggests that even under free market environment, the real interest rate is too high.

There are other considerations in the settings of the rate. One big consideration is the management of inflation. But with demand-pull inflation coming down and with downside risk as far as growth is concerned, I think there is room to make the real interest rate more accommodative to economic growth without scaring the hawks away.

Negative nominal interest rate is typically seen as impractical because nobody with profit as motivation would lend at a discount. The borrowers would hoard money at the expense of the lenders, bringing huge losses to the lenders. In a way, the consequence is like an option with unlimited loss. As a result, a supposed lender would rather hold on to their money instead of lending the money. Rather than have the borrower hoards money, the lender decides to hoard money instead.

Greg Mankiw today at the New York Times repeated an idea he blogged about in mid last month^[1] to circumvent that restriction by imposing cost on holding money that is higher than the cost of lending at a discount:

At one of my recent Harvard seminars, a graduate student proposed a clever scheme to do exactly that. (I will let the student remain anonymous. In case he ever wants to pursue a career as a central banker, having his name associated with this idea probably won’t help.)

Imagine that the Fed were to announce that, a year from today, it would pick a digit from zero to 9 out of a hat. All currency with a serial number ending in that digit would no longer be legal tender. Suddenly, the expected return to holding currency would become negative 10 percent.

That move would free the Fed to cut interest rates below zero. People would be delighted to lend money at negative 3 percent, since losing 3 percent is better than losing 10. [It May Be Time for the Fed to Go Negative. Gregory Mankiw. New York Times. April 18 2009]

I am having trouble imagining how this would work if a person or an entity does not hold cash but instead have all of their money in the banks. How exactly does this proposal work if ownership of wealth does not lead to ownership of specific bills?

Without specific ownership to a particular bill, identifying which bills to be taken out of circulation will be a problematic exercise. I foresee that by the time the time for out-of-circulation announcement arrived, everybody will place their cash in the bank, eliminating proof of ownership of particular bills to a person or entity. In effect, such act will transfer the risk of discounted face value to the banks.

To address that, it may be good to just eliminate any bills. To imitate the effect of the proposed mechanism where digits play a role, 10% (bills with a particular digit will see elimination; there are 10 digits; hence 1 out of 10) of bills should be removed from circulation instead irrespective of their serial number. That however sounds as if, regardless of level of spending, everybody will be hit with an expected 10% loss of wealth, unless a person or an entity spent all of their wealth.

Also, with money taken out of circulation, would that not increase the interest rate, running contrary to the idea of stimulating spending? This question is probably unimportant because the Federal Reserve could easily reprint the same amount of cash taken out of circulation only with different serial numbers.

^[1] — [Reloading the Weapons of Monetary Policy. Greg Mankiw. March 19 2009]