Saturday, June 6, 2009

Negative interest rates and monetary policy

Monetary policy has been constrained by the fact that nominal interest rates cannot be lowered below zero and therefore become ineffective when rates touch the zero-lower bound. William Buiter outlines three ways to make nominal interest rates negative (PPT here) - abolish currency, tax currency holding, or decouple the unit of account from the currency by introducing a new currency.

Since fiat currency has a zero nominal interest rate, the interest nominal rate on all financial assets is constrained to be no lower than zero. But it is possible to have negative nominal interest rates by abolishing currency and making do with other private means of payment - cheques drawn on bank accounts, credit cards, debit cards, cash-on-a-chip and other forms of e-money. The monetary authority could also offer every citizen an account with the central bank, which could be administered through existing commercial banks, savings banks, or post offices. These accounts, which would have to have non-negative balances, could pay positive or negative interest, as the situation demanded.

The challenge with the proposal to tax currency holdings is to "get the holder (bearer) to come forward to pay the interest due (the tax) to the central bank". But as Buiter writes, this can be overcome "if currency notes have an issue date on them, as most do, it would be very easy to announce an expiry date for currency as legal tender. The holder of the currency note would have to come forward to pay the interest due to the central bank before the expiry date. The currency would be stamped or marked in some way, to show it is current on interest due." Alternative currency taxing proposals are described by Greg Mankiw and Charles Goodhart.

Abolish the existing currency, dollar; introduce a new currency, the rallod; and keep the dollar as unit of account for bank accounts, government contracts, bank reserves with central bank, government debt etc. There would no longer be a zero lower bound on dollar nominal interest rates because there is no longer any dollar currency. There would be a zero lower bound on rallod nominal interest rates because of the existence of rallod currency. The authorities would set the exchange rate between the dollar and the rallod. For example, if the dollar interest rate set by the monetary authority has to be negative (say, - 5%) to achieve the objectives of the monetary authority, the rallod interest rate could remain zero, provided the monetary authority announced a credible appreciation of the value of the dollar in terms of the rallod (by 5%). In other words, though rallod currency has a zero interest rate, it is not a better store of value than negative interest dollar bonds because the dollar (which is no longer a currency) appreciates vis-à-vis the rallod.

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