Saturday, July 18, 2009

How to Cut Interest Rates to Below Zero

An interesting thought from Greg Mankiw, Economics professor at Harvard:
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. [...]

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. [...]

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.

-- Greg Mankiw, Reloading the Weapons of Monetary Policy


F said...

> You borrow $100 today and repay $98 a year from now.

So, a year from now, the fed will invalidate 10% of my borrowed money. Thus, I will only own $90, but have to repay $98 dollar. Thus rendering the effective interest rate almost 9%.

Stupid proposal.

Gabor said...

Maybe the 0 to 9 example wasn't clear enough.

Let's instead say you want to synthesize a -2% interest rate on cash. Every year, you'd draw two numbers from 00 to 99 out of a hat, and invalidate those serial numbers.

I think Mankiw just used 0 to 9 to simplify his example.