zero
2304 Intermediate Macroeconomics
Instructions:
Many advanced economies throughout the world have official interest rates that have been set to zero – or very close to zero, even negative in some cases – for a sustained period of time. What relevance, if any, do the macroeconomic models that you have studied have in explaining this phenomenon and predicting its likely consequences?”
* 1000 word limit.
Solution.
2304 Intermediate Macroeconomics.
Introduction
Various major economies around the world have resorted to unconventional methods of stimulating the economy. The most critical time to stimulate an economy is after there has been a depression and hence there should be an aggressive monetary policy by the relevant authorities. The central banks of major economies have turned to zero rating the interest rates to stimulate economic recovery and combat deflation (Dornbusch, 2006). Japan is one of the major economies to have attempted zero interest rates. This paper will look at zero and negative interest rates and how they impact the economy.
The monetary authority can set the interest rate at zero or even below zero in a bid to control the flow of money in the economy. The understanding behind this move is that when interest rates are reduced to zero, banks can get more money and the same is made available for loans to the public (Galí & Monacelli, n.d.). Many have viewed negative, and zero rates as a last ditch method used when all other policy items have failed. When borrowers receive loans at zero or negative interest rates, it implies that the pensioners and others with savings account receive no interest on their savings. During the period when zero rating is in use, investors are heavily subsidized to encourage borrowing to spur investment and consumption (Forelle, 2016).
The central bank sets interest rates at zero and negative for the deposits that commercial banks have (Forelle, 2016). When interests are that little, it becomes costly for commercial banks to hold on to cash reserves. The banks are forced to lend to the public so as to reduce the balances. An availability of funds at zero interest rates is likely to spur borrowing, and there is massive investment in assets. When the central banks put negative interests on the deposits of commercial banks, two things may happen. The banks might decide to cope with the policy or transfer the cost of these negative rates to the customers. When customers get charged for making deposits with commercial banks, they may opt to hoard their cash in safes and other means so as to avoid the costs. The worst-case-scenario would result in a situation where banks don’t have sufficient deposits to offer as loans to the public. It would lead to a limited flow of money in the economy which defeats the original reason of zero and negative interest. When banks decide to absorb the negative rates, it puts a significant dent into their profits. This downward pressure on bank stocks leads to a depression in equity markets.
There is a sustained period of vigorous investment in areas such as real estate and others. Eventually, the bubble bursts and the late investors are faced with very slim margins thus making it hard for them to repay the loan. In the case of inflation, the early movers with money are the largest beneficiaries of the policy. When prices go up due to inflation, there is significantly lower demand, and this results in a pool of cash in public hands with no way for them to repay (Galí & Monacelli, n.d.). This reason has led to the idea that zero rating is only good in the short term and not over a sustained period. When interest rates are at zero, the pensioners are worse off.
The central bank has the mandate to increase inflation in times where the economy has been in a slump. Regulating inflation requires sober policies when all other methods do not work. When interest rates are lowered to zero, investors are discouraged from buying the local currency. When the value of the currency goes down, there is an improvement in near-term trade exports in return for the more valuable foreign exchange. On the other hand, imports become costly, and hence inflation rises. The economy is thus able to self-regulate over time as the trade advantage continues (Dornbusch, 2006). When this happens, the value of the local currency is likely to go up hence inflation is regulated by increasing the purchasing power. Inflation is not feared but desired at manageable levels so as to reinvigorate the economy and increase the GDP.
Increasing employment is the other aim of setting interest rates at zero. When money is made available for loans, borrowers take the money and invest heavily in assets like land, housing, and shares (Forelle, 2016). There is the minimal investment in areas of new production. When production is not stimulated, employment opportunities do not increase. The monetary authority seeks to avoid deflation while regulating inflation. Cheap labor policies have made companies off-shore some of their production activities or offering low wages to workers. It helps to keep inflation low, and at the same time, the people don’t have much to spend in the economy. Low-interest rates stimulate development in areas that do not improve productivity.
When many people invest in one particular sector of the economy, the returns are likely to diminish with time since there is high competition. Investors who borrowed at zero interest now find themselves stuck with capital equipment and other investments while the expected returns take a tumble. When this happens, investment decreases and a recession ensues leading to an increase in savings brought about by uncertain investors. They prefer to be risk averse and hold onto their money since they anticipate little spending. This self-fulfilling phenomenon is known as the liquidity trap. If the investors believe that the currency will gain value in a particular economy, there is a high likelihood of vigorous investment today.
Low-interest rates are likely to lead to an increase in asset prices over time. The increase in asset price can be combined with other policy tools such as quantitative easing so as to increase the monetary base. Deflation is avoided since assets increase in price while the discretionary income in households also goes up.
The general outlook seems to signify
that negative interest rates should not be taken at face value. While it is
evident that zero interest rates will likely stimulate borrowing for investment
purposes, it has also been observed that they would damage the banking sector
if allowed to run for a prolonged period. Market stability cannot be achieved
using relatively unknown tools such as zero and negative interest rates.
References
Rabin, J. & Stevens, G. (2002). Handbook of monetary policy. New York: Marcel Dekker.
James, J. & Webber, N. (2001). Interest rate modeling. Chichester [u.a.]: Wiley.
Forelle, C. (2016). Everything You Need to Know About Negative Rates. WSJ. Retrieved 6 October 2016, from http://www.wsj.com/articles/everything-you-need-to-know-about-negative-rates-1456700481
Galí, J. & Monacelli, T. Monetary Policy and Exchange Rate Volatility in a Small Open Economy. SSRN Electronic Journal. http://dx.doi.org/10.2139/ssrn.859564
The Unseen Consequences of Zero-Interest-Rate Policy. (2015). Mises Institute. Retrieved 6 October 2016, from https://mises.org/library/unseen-consequences-zero-interest-rate-policy
Dornbusch, R. (2006). Macroeconomics. North Ryde, N.S.W.: McGraw-Hill Australia.