In the book, they claim that monetary policy cannot fight against deflation. However let me propose a scenario:
Nominal Interest Rate = 8%
Inflation = 1%
Real Interest Rate = 7%
then deflation kicks in (-1% inflation) which causes the real interest rate to rise to 9%.
However, couldn’t the central bank merely lower the nominal interest rate to, let’s say, 5%, which would make the real interest rate 6%, and thus this lowering of the real interest rate could create an expansionary monetary policy and boost the economy?
In a deflationary environment, Consumers “expect” prices in the future to be lower than current prices.
Therefore, they reduce/delay current consumption.
Real Interest Rate ~ Nominal Interest Rate - Expected Inflation, Nominal Interest Rate > 0
To lower the Nominal Interest Rate the Central Bank would increase the money supply circulating in the economy (by buying bonds with newly created cash). This in isolation you would think should stimulate the economy, at least over time.
However, sometimes deflation expectations tend to reinforce from one period to another and by the time the above policy change really takes effect (yes, there are time lags between when a monetary policy change occurs and its intended effects cascade through to the economy), expected deflation could be much more. So deflation expectations play a critical role here. Moreover, there is a limit to the amount that the nominal Interest rate can be lowered since it needs to be greater than zero.
Therefore, Monetary policy alone is ineffective in combating deflation.
Could you explain this in the context of my example that I provided initially? It would help me understand what you are trying to say much more easily.
Thanks!
Sure.
You start by setting up Nominal Int = 8% , Inflation = 1% and Real Int = 7%
Then Inflation = -1% and your suggested policy response is make Nominal Int = 5%
since Real Int = 5% - (-1%) = 6%
So the expansionary effects (from a Real of 6% compared to 7%) that you hope to achieve with the 5% Nominal Int rate take time to come to fruition. They don’t happen immediately. For example, let’s assume it takes a year.
However, deflation expectations can reinforce over those 12 months. So by the end of the 12-months deflation may be -3% instead of -1% and the Real Int = 5% - (-3%) = 8%. So what will you do next ? You could lower the Nominal rate further. But there is a limit to which this can be done - that is, Nominal rate cannot go below zero. However, if the problem were inflation there is in theory no limit to which you can raise the nominal rate.
Why cant the central bank issue negative nominal interest rates? They could merely charge bankers for keeping money with them (as implied by negative interest rates)…
Well they can if they really wanted to and a few already have.
But it appears to be a last resort desperate measure since it exposes the economy to potential instability. The article below explains why the negative interest rates may not solve the problem.
http://www.economist.com/blogs/economist-explains/2015/02/economist-explains-15
"Since cash carries an implicit rate of interest of 0%, consumers might well respond to negative rates by withdrawing money from banks and stuffing it in their mattresses. The resulting shortage of loanable funds would push interest rates up (though perhaps not before causing an economy-crushing bank run). "