### Observations on Negative Interest Rates

My article on negative interest rates generated more than the usual volume of email, some of it quite heated. While I cannot possibly respond to all of it, let me add a few wonkish comments about the topic, from a variety of perspectives:

1. If r is the real interest rate, then the relative price of consumption tomorrow in terms of consumption today is 1/(1+r). Is there anything in economic theory that requires this relative price to be less than one? Unless consumption goods are costlessly storable, which they aren't, I do not think so. Just as the price of apples can be more or less than the price of pears, the price of consumption tomorrow can be more or less than the price of consumption today. If people are eager to defer consumption, then consumption tomorrow could well be more expensive than consumption today--that is, the equilibrium real interest rate could be negative.

2. Most ec 10 students begin thinking about the interest rate in terms of the supply and demand for loanable funds. That works perfectly here. The recent declines in housing and stock-market wealth have increased Americans' propensity to save. That is, we have increased the supply of loanable funds. There is no reason to presume that the equilibrium interest rate consistent with full employment is necessarily in the upper right quadrant of the Cartesian plane.

3. Higher uncertainty drives up risk premiums. In a Lucas asset pricing model, a higher risk premium could occur in equilibrium with a lower risk-free rate, rather than a higher return on risky capital. As uncertainty increases, the risk-free rate could easily be pushed into the negative region. (If you need convincing on this point, see equation 3.9 in this paper.)

4. The above three points are aimed at establishing that there is nothing particularly radical in the idea of a negative real interest rate from the standpoint of economic theory. But are we really there? That is an empirical question. When I calibrate my favorite version of the Taylor rule using the most recent data, I get a target for the nominal federal funds rate of about negative 1 percent. That means an even more negative target for the real interest rate, as long as expected inflation is still positive. And given the forecasts of inflation and unemployment, we are likely to get further into the negative region in the months to come.

5. If we want to prop up aggregate demand to promote full employment, what is the alternative to monetary policy aimed at producing negative real interest rates? Fiscal policy. Essentially, the private sector is saying it wants to save. Fiscal policy can say, "No you don't. If you try to save, we will dissave on your behalf via budget deficits." That fiscal dissaving would push equilibrium interest rates upward. But is that policy really welfare-improving compared to allowing interest rates to fall into the negative region? If people are feeling poorer and want to save for the future, why should we stop them? Unless we think their additional saving is irrational, it seems best to try to funnel that saving into investment with the appropriate interest rate. And given the available investment opportunities, that interest rate might well be negative.

1. If r is the real interest rate, then the relative price of consumption tomorrow in terms of consumption today is 1/(1+r). Is there anything in economic theory that requires this relative price to be less than one? Unless consumption goods are costlessly storable, which they aren't, I do not think so. Just as the price of apples can be more or less than the price of pears, the price of consumption tomorrow can be more or less than the price of consumption today. If people are eager to defer consumption, then consumption tomorrow could well be more expensive than consumption today--that is, the equilibrium real interest rate could be negative.

2. Most ec 10 students begin thinking about the interest rate in terms of the supply and demand for loanable funds. That works perfectly here. The recent declines in housing and stock-market wealth have increased Americans' propensity to save. That is, we have increased the supply of loanable funds. There is no reason to presume that the equilibrium interest rate consistent with full employment is necessarily in the upper right quadrant of the Cartesian plane.

3. Higher uncertainty drives up risk premiums. In a Lucas asset pricing model, a higher risk premium could occur in equilibrium with a lower risk-free rate, rather than a higher return on risky capital. As uncertainty increases, the risk-free rate could easily be pushed into the negative region. (If you need convincing on this point, see equation 3.9 in this paper.)

4. The above three points are aimed at establishing that there is nothing particularly radical in the idea of a negative real interest rate from the standpoint of economic theory. But are we really there? That is an empirical question. When I calibrate my favorite version of the Taylor rule using the most recent data, I get a target for the nominal federal funds rate of about negative 1 percent. That means an even more negative target for the real interest rate, as long as expected inflation is still positive. And given the forecasts of inflation and unemployment, we are likely to get further into the negative region in the months to come.

5. If we want to prop up aggregate demand to promote full employment, what is the alternative to monetary policy aimed at producing negative real interest rates? Fiscal policy. Essentially, the private sector is saying it wants to save. Fiscal policy can say, "No you don't. If you try to save, we will dissave on your behalf via budget deficits." That fiscal dissaving would push equilibrium interest rates upward. But is that policy really welfare-improving compared to allowing interest rates to fall into the negative region? If people are feeling poorer and want to save for the future, why should we stop them? Unless we think their additional saving is irrational, it seems best to try to funnel that saving into investment with the appropriate interest rate. And given the available investment opportunities, that interest rate might well be negative.

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