Friday, January 20, 2012

The Unconquerable Zero Lower Bound

I've read a number of techniques that would allow the Federal Reserve to breach the zero lower bound and create a negative, real interest rate. That, they theorize, would encourage people to start spending, since saving money would cause real losses for the savers.

That theory is false. I posit that, in any non-extreme economic circumstance, people's saving preference forms a serpentine curve with interest rates.

At the lower end of the interest rate spectrum, where we are now, people save for purposes which are relatively immune to the interest rate--typically to "self-insure" in uncertain economic times. Indeed, a negative real interest rate would work at cross-purposes, since, to meet this need, savers would have to save MORE to make up for the real losses they're taking. Thus, the savings curve flattens (and may even rise) at the lower bound. That must make Keynes spin in his grave.

On the other end of the curve, when interest rates are extremely high, a further increase in interest rates would generate little additional saving, since those resources that could easily be devoted to savings had already been saved. In fact, such a high interest rate could cause the savings rate to decrease, since assets would be pulled out of productive investments and devoted to savings. Thus, the savings curve flattens again as all available resources are devoted to savings.

So any attempt by the Federal Reserve to breach the zero lower bound is doomed to failure. At some point, we have to admit that there are some things that monetary policy cannot do.


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