Zero interest-rate policy

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Zero interest-rate policy (ZIRP) is a macroeconomic concept describing conditions with a very low nominal interest rate, such as those in contemporary Japan and, since December 16, 2008, in the United States. It can be associated with slow economic growth.

Under ZIRP, the central bank maintains a 0% nominal interest rate. The ZIRP is an important milestone in monetary policy because the central bank is no longer able to reduce nominal interest rates—it is at the zero lower bound. Conventional monetary policy is at its maximum potential to drive growth under ZIRP. ZIRP is very closely related to the problem of a liquidity trap, where nominal interest rates cannot adjust downward at a time when the loanable funds market has not cleared.

However, some economists—such as market monetarists—believe that unconventional monetary policy such as quantitative easing can be effective at the zero lower bound.

Others argue that when monetary policy is already used to maximum effect, to create further jobs, governments must use fiscal policy. The fiscal multiplier of government spending is expected to be larger when nominal interest rates are zero than they would be when nominal interest rates are above zero. Keynesian economics holds that the multiplier is above one, meaning government spending effectively boosts output. In his paper on this topic, Michael Woodford finds that, in a ZIRP situation, the optimal policy for government is to spend enough in stimulus to cover the entire output gap.[1]

Chris Modica and Warren Sulmasy find that the ZIRP policy follows from the need to refinance a high level of US public debt and from the need to recapitalize the world's banking system in the wake of the Financial crisis of 2007–2008.[2]

Zero lower bound[edit]

The zero lower bound problem refers to a situation in which the short-term nominal interest rate is zero, or just above zero, causing a liquidity trap and limiting the capacity that the central bank has to stimulate economic growth. This problem returned to prominence with the Japan's experience during the 90's, and more recently with the subprime crisis. The belief that monetary policy under the ZLB was effective in promoting economy growth has been critiqued by economists Paul Krugman, Gauti Eggertsson, and Michael Woodford among others. Milton Friedman, on the other hand, argued that a zero nominal interest rate presents no problem for monetary policy. According to Friedman, a central bank can increase the monetary base even if the interest rate vanishes; it only needs to continue buying bonds.[3] (Note: The quote from footnote #3 may be misleading. Friedman was talking about Japan in 1989, when Japan's very tight monetary policy produced deflation which resulted in a zero interest rate. Friedman wasn't exactly advocating the "Quantitative Easing" that's been the Fed's strategy from 2008 to 2014. (7/30/2014))

Pros and Cons of Zero Interest Rate Policy (ZIRP)[edit]

Positives:

1) By lowering the cost of capital, cheap money encourages businesses to lever up and invest the proceeds and consumers to borrow and spend to boost the economy.

2) Refinancing existing debt becomes highly attractive.

3) Lifts asset prices if you happen to own them as about 50% of households don’t own any stocks or mutual funds.

4) With a lower discount rate, the present value of future cash flow turns higher.


Negatives:

1) Negative real interest rates is killing savers in order to bailout over indebted borrowers.

2) Pension funds are becoming more and more dangerously underfunded, threatening the retirements of many individuals and the balance sheets of companies and governments.

3) Artificially set interest rates misallocates capital, results in malinvestment, and distorts and manipulates markets.

4) The pricing mechanism/discovery is damaged if the cost of money is fake.

5) Debases the US$ (CPI index, a measure of inflation, may increase as a result).

6) Massive monetary inflation is price inflation tinder box.

7) Deeper the Fed digs, the harder it will be to climb out.

8) The wealth effect is fleeting and so is its economic impact.

9) Cost of money doesn’t matter when huge deleveraging needs to take place.

10) Fed engineered easy money creates illusory feel of an economic fix.

11) Cheap money is conducive to increased federal government borrowing and spending.[4]

See also[edit]

References[edit]

  1. ^ Woodford, Michael (2011). "Simple Analytics of the Government Expenditure Multiplier". American Economic Journal 3 (1): 1–35. doi:10.1257/mac.3.1.1. 
  2. ^ Modica, Chris; Sulmasy, Warren (March 27, 2013). "Why the Federal Reserve Bank Has a Near Zero Interest Rate Policy". Yahoo! Finance. 
  3. ^ "Milton Friedman's Keynote address at the Bank of Canada". 
  4. ^ Pro’s/Con’s of Fed Policy (with more to come) | The Big Picture

Further reading[edit]

  • Eggertsson, Gauti B.; Woodford, Michael (2003). "The Zero Bound on Interest Rates and Optimal Monetary Policy". Brookings Papers on Economic Activity 2003 (1): 139–211. doi:10.1353/eca.2003.0010. JSTOR 1209148. 

External links[edit]