Talk:Liquidity trap

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Is there any in principle reason why interest rates could not drop below 0, at least for state owned banks? Mark Richards 23:22, 27 May 2004 (UTC)

Well, I think it is inherent in the concept of interest rates. They are "rent" on money, right - someone lends someone else money and receives 'interest' for that service. So negative interest rates would be just like someone throwing money at you to live in their appartment or someone giving you extra money for borrowing their money. However, someone who definitely knows what he's talking about seems to suggest that there is such a thing as negative interest rates. Check out Paul Krugman's article on the Liquidity Trap: [web.mit.edu/krugman/www/trioshrt.html] Cheers, User:Tmstapf

Well, intuitively yes, but in reality, lending below the rate of inflation is throwing money away (forget for the moment that we are talking about an example where inflation is also zero). You break even on lending if you lend at the rate of inflation, anything above that is profit, below it is loss. Governments frequently lend at rates below what they could get at market in order to increase the availability of capital in the market, to stimulate growth - they incur a loss against what they could in theory 'rent' the money for in return for political gain of stimulating the economy. I don't see why they could not, as inflation approaches zero, and if interest rates were also zero, lend at below that for the same reason. I agree that the scenario is unlikely. Mark Richards 05:51, 29 May 2004 (UTC)

Sure I agree that governments often lend/spend for the political gain rather than the profit (political gain is so to say government's profit). But still I cannot see a negative interest rate making sense. If I borrowed $5 from you today, promising to give it back to you in a year at -10% interest I would need to give you back only $4.50 at the end of the year. So in effect you would pay me to take your money. And even though governments are sometimes desperate to gather political support I don't think they would need to do this, because people are going to be happy to take their money already at 0% interest rate.

Your assumption is that the inflation rate is 0%. This is why it appears that the real interest rate can't be negative.

Let's bring inflation into it. Let's say you lend me $100 with a nominal interest rate of 10%. Now, let's say (for the sake of this discussion) that the real inflation rate is also 10%. In one year, then you would need $110 in value to equal the value that you have in the $100 today. Thus, the real interest rate of the loan that you gave me would be 0%. That is, you would have $110 in one year, but that $110 at the end of that year is worth the same as the $100 that you have now. You would not have a net gain.

Now, let's say that you charge me only 5% nominal interest, with an inflation rate of 10%. In 1 year, you will get back $105, which is worth less than the $100 that you have now (remember, you need at least $110 to match the value that you have now). You have, in effect, "paid" me the other $5 because I got the value out of that money immediately, before the interest rate affected it.

This is why it is possible to have a negative real interest rate. The nominal rate can't go below 0%, but if the inflation rate is higher than the nominal rate, then the real rate is negative. The key here is understanding the distinction between the nominal and real rate.--76.104.90.6 03:24, 8 October 2007 (UTC)

Wouldn't it just end up being a partital grant? There are many examples of govts giving grants, subsidies and tax breaks along with loans to encourage business to one thing or another. I guess this is the practical manifestation of negative interest rates. Mark Richards 15:50, 1 Jun 2004 (UTC)

There is a very good reason why interest levels cannot drop below zero. If the central bank decided to do so it would mean offering money that din't already exist. So it would need to increase M1. But such an increase would merely correspond to what Krugman already suggested. Hence it is useless to discuss interest levels below zero because that simply means increasing the amount of money. Also, if the interest is 0 demand will be explosive which means that the central bank would have to impose direct quantative restrictions on M1 rather than using the interest rate to clear the money market. This would effectively disrupt the money market and result in adverse effect on the goods market and in turn labor market. This is why central banks prefer to use the interest rate. One notable exception is if the central bank is following a fixed exchange rate rule. In such a case the central bank cannot set the interest by itself but needs, roughly speaking, to accept it as given. In this case the central bank does indeed regulate M1 directly but in this case interest levels below or at 0 would imply other problems beyond the scope of this article. MartinDK 13:37, 19 October 2006 (UTC)

That's not true. REAL interest rates can go below 0%. It is only the nominal interest rate that cannot go below 0%. The REAL rate is the nominal rate corrected for inflation. As stated above, if the inflation rate is higher than the nominal rate, then real interest is negative.--76.104.90.6 03:26, 8 October 2007 (UTC)