Essay: negative interest rates without any changes to the monetary system

Essay details:

  • Subject area(s): Business essays
  • Reading time: 5 minutes
  • Price: Free download
  • Published on: January 12, 2020
  • File format: Text
  • Number of pages: 2
  • negative interest rates without any changes to the monetary system
    0.0 rating based on 12,345 ratings
    Overall rating: 0 out of 5 based on 0 reviews.

Text preview of this essay:

This page of the essay has 1421 words. Download the full version above.

The aura around the liquidity trap is that once the zero lower bound on the interest rates is hit, the interest rates can not be lowered any further. Looking at the figure above, suppose that the economy is in equilibrium at point A. Through monetary expansion, the central bank can shift the LM curve to LM’ and effectively increase output from Y to Y’ with the new equilibrium at point B and the interest rate decreasing from i to 0. However, if the economy is at point B and central bank tries to increase output using expansionary monetary policy it will shift the LM’ curve to LM’’ but the output will remain at Y’ at point B, the intersection point of the IS-LM curve. Monetary expansion will not work. The central bank’s effort to increase liquidity falls into a trap; the interest rates cannot go further down than zero. The consensus being that at zero interest rates consumers would rather hold cash than bonds, reducing liquidity (Blanchard et al., 2010). This essay will look into the different ways that the zero lower bound can be breached and send the interest rates into a negative territory.

Introducing negative interest rates without any changes to the monetary system

It was argued that as the interest rates turn to zero, the demand for cash would become infinite as shown by the first graph in figure 2.
However, in the modern era of low rates, it has been demonstrated that interest rates can go to zero without money demand exploding, ruling out the first case. Most recently a few countries such as Denmark, Switzerland and Sweden as well as the European Central Bank have crossed into the negative interest rate territory. The idea behind negative rates is that banks are charged for hoarding cash and keeping deposits. In response to this they will get rid of the cash by lending, actually increasing demand in the economy. Although it is too early to tell, the cash demand has remained finite. This shows that money demand is rather a constant semi-elasticity and gradually expands as rates go below zero as shown in the second graph above (Mathew, 2015). Figure 3 further illustrates the same point. The cash in circulation in the Swiss economy against the target rate has not been much affected by the implementation of negative interest rates. Nonetheless, there is a downside to this approach. Since positive rates act as a tax on money; negative interest rates subsidise it. This can cause the central bank to lose a lot of money on an annual basis but they can set this off by taxing it later on (Mathew, 2015). Another concern is that if the demand for money becomes increasingly elastic further down the negative territory, it could turn out to be much more costly to deviate from the Friedman rule (optimal interest rate is zero) on the negative side rather than the positive one.

Negative interest rates with changes to the current system

Paper money is widely accused of hindering the central bank’s ability to introduce negative interest rates. Many believe that the current form of monetary system has to be tweaked in some way or completely changed in order to grant banks an increasing control to venture into negative territory. One of these views is to introduce a carry tax on money. If due to excess reserves the interbank rate were to fall to zero, a central bank can impose a carry tax on the electronic reserves. As the banks try to offload the excess reserves they will push down the interbank rate below zero. However, it will not go further than the storage cost in nominal terms, as banks will refuse to lend below that rate (Goodfriend, 2000). Again, if the large negative interest rates are expected for a long time then people will start hoarding money. A way around this problem is to start taxing currency. The central bank can fix the tax on currency and then can manipulate the interest rate between zero and the negative of the fixed tax that has been imposed.

Technological advancements mean that central banks can monitor and impose such taxes on reserves but for the currency to be taxed a system needs to be put in place that will check for how long the cash was in circulation, let us say from one transaction to another, and will be taxed accordingly. This will curb hoarding as people will be charged for the amount they hold in the currency and will therefore rather lend it; doing away with the liquidity problem. Fitting barcodes or chip in the paper money will allow for cash holders to be identified and taxed. This way a carry tax can also be levied when the bill is deposited in a bank by checking the circulation duration.

Open market operations can be performed simultaneously with this strategy to make it more efficient. The downside to this is that there will be enormous costs to put the monitoring systems in place to stamp the currency as current and also to print the new recordable currency (Goodfriend, 2000). Another one could be that if money is being taxed people might start the use of foreign currencies.

Another way of taxation is provided by Mankiw, who introduces the idea of eliminating money ending with a particular serial number through a lottery system announced a year in advance. Again, holding money will yield negative expected return. The ‘ bank can adjust the rates into the negative and increase lending as long as the rate is above the negative return from cash (Mankiw, 2009). This too has its shortcomings. Although the currency will lose its legal tender, it might still be able to circulate in the economy, as some agents might be willing to accept it. The value of paper money is what people believe it to be. This problem can be overcome by fining the perpetrators or those found in possession of the expired money (Buiter, 2009). However, such systems of checks are likely to be very unpopular amongst the public.

An entirely radical way to the ones mentioned before is to get rid of cash completely. Cash gives a zero nominal interest rate and because of this, it creates a lower bound. The argument behind it is that it is easy for advanced economies to move over to a system of electronic money. Electronic money in the form of debit, credit cards, etc. is already in wide usage. This makes the implementation of negative interest rates as easy as the positive rates (Buiter, 2009). Furthermore, it has been argued that large denominations of cash should not exist in the first place as they facilitate and subsidise criminal activities. A less drastic measure would be to keep the currencies in small denominations, say no more than £5 or £10. This would increase the carry costs for cash and shift the zero lower bound into the negative territory. On the other hand, the argument against abolishing currency is that of seigniorage. The anonymity that was held by the owner of the cash will be lost and might lead to a decrease in demand. However, taxing the underground economy that will surface because of the abolishment of cash can offset this (Rogoff, 2014).

The myth that interest rates cannot go into the negative and result in a liquidity trap at or near zero has been proven to be false. As shown in the essay there are various ways to break the lower bound. Japan, Denmark, Switzerland, Sweden and the ECB have effectively kept their interest rates below zero for a while now and to some good extent as well. Although it is too early to look for the outcome of this experiment one thing that is certain is that traditional policies have failed and proved to be ineffective and have called for desperate measures to be put into place. There are also new concerns for the economy in this environment. By not passing on the costs of the negative interest rates on to customers, banks are having their profit margins between the lending and deposit rates reduced. This may lead them to hold onto more cash rather lend. Another point that was raised in a recent report by the Bank for International Settlements was that if the rates are negative for an extended period of time it might lead to a currency war. If the economies do come over these problems and the negative interest rates do work, it may yet start a new age for central banks.

About Essay Sauce

...(download the rest of the essay above)

About this essay:

This essay was submitted to us by a student in order to help you with your studies.

If you use part of this page in your own work, you need to provide a citation, as follows:

Essay Sauce, negative interest rates without any changes to the monetary system. Available from:<https://www.essaysauce.com/business-essays/negative-interest-rates-without-any-changes-to-the-monetary-system/> [Accessed 04-08-20].

Review this essay:

Please note that the above text is only a preview of this essay.

Name
Email
Review Title
Rating
Review Content

Latest reviews: