Reloading the Weapons of Monetary Policy Some people are concerned that in the the fight against recession, the weapons of monetary policy are nearly out of ammunition. That is certainly the case for the standard monetary weapon--cuts in short-term interest rates. Afterall, short-term interest rates are already about zero, and the Fed cannot cut interest rates below zero.

Or can it? In a discussion at a Harvard seminar recently, a clever grad student proposed a solution to the zero-lower-bound problem.

Let's begin with the basics: Why can't the Fed cut interest rates to below zero?

Why can't the Fed announce, for example, an interest rate of negative 2 percent? You borrow $100 today and repay $98 a year from now. A negative interest rate would certainly encourage people to borrow and spend, thereby expanding aggregate demand. And if negative 2 percent wasn't enough to get the economy going, we could try negative 3 percent. And so on.

The problem, you might reply, is that no one would lend money on those terms. Rather than lending at a negative interest rate, you could hold onto cash by, for example, stuffing it in your mattress. In other words, the interest rate on loanable funds cannot fall below zero because holding cash guarantees a rate of return of zero. If the Fed tried to cut interest rates below zero, money would dominate debt instruments as a portfolio investment.

With this background, I can now state the proposed solution: Reduce the return to holding money below zero. Imagine that the Fed were to announce that, one year from today, it would pick a digit from 0 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 2 percent. Losing 2 percent is better than losing 10. Of course, some people might decide that at those rates, they would rather spend the money by, for example, buying new car. But since expanding aggregate demand is precisely the goal of the interest rate cut, that incentive is not a bug but a feature!

Okay, I understand that this plan is not entirely practical. But you have to give the student credit for thinking out of the box. And his plan does address a fundamental problem facing the economy right now: Given the fall in wealth, increases in risk premiums, and problems in the banking system, the interest rate consistent with full employment might well be negative.

## Friday, March 20, 2009

### Negative real interest rates

Let's say that in the current macroeconomic environment a negative real interest rate is required to ensure full employment (ie where desired savings equals desired investment), given that all countries cannot export their way out of recession. One way to generate a negative interest rate is to have the central bank credibly commit to inflation. Greg Mankiw provides another strategy.

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