What happens if real interest rate is negative

First, the ZLB is the cause of unemployment and stagnation as it prevents the nominal interest rate from falling, thereby blocking the real interest rate from falling to the NRI. Second, the underlying economic belief is that a lower real interest rate can always solve the problem of aggregate demand shortage.

It is assumed to do so by increasing investment demand and reducing saving. Third, the core economic theory behind the ZLB story derives from pre-Keynesian classical macroeconomics. At the center of classical macroeconomics is the loanable funds theory of interest rates, according to which saving and investment are coordinated via adjustment of the real interest rate, thereby delivering full employment. The real interest rate i. In New Keynesian models, this classical interest rate adjustment mechanism is managed by the central bank via its nominal interest policy.

The central bank sets the nominal interest rate aiming to target an inflation rate consistent with its belief regarding the NRI required for clearing the loanable funds market 7. Fourth, though the core theory derives from classical macroeconomics, the economy can appear Keynesian because output adjusts when the real interest rate cannot.

In normal times, the real interest rate adjusts to balance full employment saving and full employment investment to ensure AD equals full employment aggregate supply AS. However, when the real interest rate cannot adjust as at the ZLB , output does the adjusting to align as with AD.

That gives the economy its Keynesian look. Fifth, there are two policy solutions to the problem as diagnosed by ZLB economics. Solution number one is for the monetary authority to drive up inflation expectations. Since the real interest rate is equal to the nominal interest rate which is stuck at zero minus expected inflation, a higher expected inflation rate lowers the real interest rate.

However, that is easier said than done as inflation expectations appear to be determined by expectations of real economic conditions rather than pronouncements by the monetary authority. Solution number two is for the monetary authority to set a negative nominal interest rate. In principle, it can do this directly by setting its own lending rate below zero, or alternatively it can adopt non-standard tools such as charging commercial banks for their deposits with the central bank.

Either way, according to the reasoning embodied in ZLB economics that should solve the problem of demand shortage. The ZLB hypothesis has now become received wisdom regarding stagnation, and it has significantly informed policy discussion over negative interest rates. The classical dimension concerns its thinking about interest rates and their role in the economy.

The Neo-Keynesian dimension is the belief that a rigidity i. Both aspects of ZLB economics are wrong. The challenge was directed at both the theory of interest rate determination and the theory of interest rate effectiveness. First, Keynes challenged the classical claim that interest rates are determined by the supply saving and demand investment for loanable funds, thereby equilibrating goods market AD and as. According to Keynesian economics, the loanable funds market is a fiction that does not exist, so interest rates cannot be determined in this way.

Instead, Keynes proposed that interest rates were determined according to his liquidity preference theory. Asset prices and interest rates adjust to ensure asset demands including the demand for money equal asset supplies. Second, Keynes argued that AD and as are primarily equalized via output adjustment, rather than interest rate adjustment.

That is Keynes famous theory of demand-determined output. According to Keynesian economics, it is the level output i. Of course, interest rates may be affected as output adjusts owing to the impact of changing income on portfolio demands for financial assets, but that interest rate impact is a secondary induced income effect. The Keynesian construction of the economy is therefore completely different from the classical construction. Third, for Keynesians, it is possible that saving and investment may not respond to lower interest rates as assumed by classical macroeconomics and modern-day ZLB economics.

Figure 2 depicts the competing theoretical positions regarding interest rate ineffectiveness. The debate is divided between arguments that identify nominal interest rate rigidity as the problem versus arguments that identify the interest rate insensitivity of AD as the problem. Figure 2. The debate over the macroeconomic ineffectiveness of interest rates.

The Neo-Keynesians made arguments on both sides of the debate but, as argued below, their arguments regarding the interest rate insensitivity were not adequate. With regard to nominal interest rate rigidity, the Neo-Keynesians emphasized the liquidity trap Keynes, , p. ZLB economics is also a nominal interest rate rigidity argument, and it blends with the arguments of both Keynes and the Neo-Keynesians. First, rather than identifying intermediation costs as the source of the interest rate floor, ZLB economics attributes the floor to the pure rate of interest and the existence of money which pays zero interest.

Second, ZLB economics misleadingly calls this floor a liquidity trap Palley, Doing so gives ZLB economics a rhetorical edge that helps it masquerade as being Keynesian in spirit. However, the ZLB is not the same as the liquidity trap. In the liquidity trap expansionary open market operations cannot affect asset prices and interest rates, making QE is ineffective.

Thus, the ZLB serves as a new nominal rigidity for explaining unemployment, supplementing existing Neo-Keynesian explanations built on price and nominal wage rigidity. The right-hand side of Figure 2 shows interest insensitivity of AD as the other side of the debate. If AD is interest insensitive, lowering the nominal interest rate has no impact on employment and output, rendering the issue of nominal interest rate rigidity irrelevant for explaining unemployment.

Furthermore, there may be no interest rate capable of delivering full employment i. Neo-Keynesians captured this possibility via a vertical IS schedule, which was justified by the claim of zero interest elasticity of investment demand. They argued full employment could be blocked off because either the LM was horizontal due to the liquidity trap, or because the IS was vertical due to the interest insensitivity of investment demand.

The Neo-Keynesians therefore invoked both interest rate rigidity and interest rate ineffectiveness. However, and important and faulty feature of their thinking was to separate investment demand interest rate insensitivity of the vertical IS and money demand interest rate rigidity of the horizontal LM.

In contrast, as argued next, Keynes had a unified theory in which investment demand and money demand interacted and were two sides of a common argument. Neo-Keynesians argued lower interest rates would not solve the AD shortage problem if investment was interest insensitive. However, the microeconomics of that argument were never properly worked out.

An unfortunate implication of the Neo-Keynesian framing of the investment shortage problem was it squeezed money out of the picture, making it look as if the investment function was the source of the problem and money had nothing to do with it 8. NRAs consist of money, real estate, precious metals and precious minerals, works of art, patents and copyrights, rent streams generated by firms with market power. New capital i. That competition links investment demand, money demand, and demand for NRAs.

The possibility that investment could be displaced by NRAs with higher returns was identified by Keynes , pp. Our conclusion can be stated in the most general form taking the propensity to consume as given as follows. No further increase in the rate of investment is possible when the greatest among the own-rates of own-interest of all available assets is equal to the greatest amongst the marginal efficiencies of all assets, measured in terms of the asset whose own-rate of own-interest is greatest.

In a position of full employment this condition is necessarily satisfied. But it may be satisfied before full employment is reached, if there exists some asset, having zero or relatively small elasticities of production and substitution, whose rate of interest declines more slowly as output increases, than the marginal efficiencies of capital-assets measured in terms of it Keynes, , p.

Instead, it is best to talk about the firm as the locus of investment activity. Firms can be considered as real sector multi-input multi-output financial intermediaries. They take finance from different sources and use that finance to hold different types of assets that produce different returns, and this multi-input multi-output choice has analogies with portfolio decision making.

When framed in this way, it explains why negative nominal interest rates may not alleviate the problem of aggregate demand shortage. The reason is once the marginal efficiency of investment MEI hits zero, firms will prefer to use additional finance to acquire NRAs whose marginal return is still positive.

Consequently, the ZLB floor is not the problem. Instead the problem is the existence of NRAs, including money. Money is a distinct type of NRA. The existence of money explains the existence of the ZLB, but the deeper problem for investment is the existence of NRAs with higher returns than investment. Consequently, even if the central bank were to make the nominal cost of finance negative i.

Furthermore, if the return on money is negative, firms will shift toward holding other NRAs. The argument can be illustrated with the following simple partial equilibrium model of investment and asset allocation On the asset side, firms have an initial capital stock K 0 which they can increase via new investment I , and they can also hold money M and NRAs G.

Each asset has its own pattern of diminishing marginal returns. The marginal return to investment eventually becomes negative owing to the diminishing marginal efficiency of investment The marginal return to non-produced stores of value is diminishing but always strictly positive. Money has a diminishing positive own return i. The interest rate on money is the central banks money market rate minus a fixed intermediation cost a fixed charge per dollar deposited. If the interest rate on money is negative, the marginal total return on money can turn negative.

On the liabilities side, firms are financed by a mix of equity E and loans L and there is a positively sloped supply of each type of finance. The loan rate is a mark-up over the money market interest rate plus a default premium that increases with lending owing to declining credit worthiness of marginal borrowers. Figure 3 shows the pattern of rates of return on different assets and the supply function for different types of finance Figure 3.

Nominal rates of asset returns and costs of finance. In equilibrium, firms equalize the marginal costs of sources of funds with marginal benefits from application of funds so that rates of return and cost are equalized.

The solution is illustrated in Figure 4. The total demand for assets is obtained by summing the different asset demands. All variables are in real terms, deflated by the general price level. The total supply of finance is obtained by horizontally summing the different sources of supply The intersection of demand and supply determines the equilibrium return on assets and cost of finance.

The mix of asset holdings and sources of finance is then determined by the individual demand and supply functions at the equilibrium rate of return.

Monetary policy works by lowering the money market risk free interest rate. That shifts down the loan supply function and also lowers the return on money holdings via a lower deposit rate. First, firms switch from equity finance to loan finance because loan finance is cheaper. A lower policy interest rate induces firms to return equity to shareholders and adopt a more risky balance sheet financing structure.

Second, firms reduce money holdings and increase investment capital accumulation and holdings of NRAs. Now, suppose the monetary authority sets a negative interest rate by targeting a negative money market rate. The loan supply shifts down and its initial portion becomes negative.

Money demand also shifts down and its end portion becomes negative. With regard to financing of firms, if the money market interest rate is sufficiently negative so that the loan rate is sufficiently low, firms may switch completely to loan finance.

They do this via debt-financed share buybacks and special dividends that return all equity to shareholders. Given the marginal return to NRAs is always greater than or equal to zero, there comes a point when all extra loan finance from negative loan rates will be directed to increasing holdings of NRAs rather than investment.

In sum, the ZLB is not the problem. The problem is the existence of NRAs such as money, real estate, precious metals, commodities, assets like patents and copyrights, rents streams derived from monopoly power, and assets like technical knowhow and organizational capital embodied in existing firms.

Negative interest rates will contribute to bidding up the price of those assets but will not increase investment. It shows why negative interest rates will not increase investment.

Instead, firms will increase leverage, buy-back equity, and bid up the price of non-produced assets via take-overs. Additionally, there are other structural factors that limit investment spending. First, production function theory is critical. In neoclassical theory additional capital can always be put to use because of perfectly smooth substitutability between capital and labor, which means it is impossible to have excess capital. However, if production is characterized by Leontieff conditions or capital is putty-clay in nature, it is possible to have excess capital in times of demand shortage, which will further constrain the sensitivity of investment to negative interest rates.

Second, capital is long-lived and lumpy. In a multi-period model, the willingness to use low interest rate loans to finance investment today depends on expectations of future interest rates. Third, in neoclassical capital theory the MEI schedule is determined by technological conditions. Keynes had in mind a different construct in which the MEI depended on the state of animal spirits and perceptions of the fundamentally uncertain future.

In this case the MEI may shift toward the origin in bad times, making it even more difficult to increase investment. The other side of the Keynesian AD shortage problem is saving. That raises the question if negative interest rates cannot increase investment, can they increase AD by reducing saving? Here too, the answer is probably not. First, in pure consumption theory a lower real interest rate gives rise to both positive inter-temporal substitution and negative income effects.

Consequently, the theoretical effect of lower real interest rates on consumption is ambiguous. The conflict between substitution and income effects is easily understood.

Negative interest rates provide an incentive to save less and consume now. Balanced against that, negative interest rates lower future income and total lifetime income, which gives an incentive to increase saving to compensate for that loss. For instance, consider the case of a household which lives for two periods, has a zero discount rate, income of y in period 1 and zero income in period 2. The real interest rate is r. Second, a negative nominal interest rate on money holdings i.

Balanced against this, there will be a positive wealth effect on AD owing to the portfolio shift away from money to NRAs that increases the price of those assets. Theoretically, the net impact of negative nominal interest rates on saving and AD is therefore ambiguous.

Negative interest rates could reduce saving, but they could also increase saving. Negative interest rates are a monetary policy tool for unprecedented economic times, and some argue they require complementary regulations to make them work.

This is a BETA experience. You may opt-out by clicking here. More From Forbes. Nov 10, , am EST. Nov 4, , pm EDT. Nov 3, , am EDT. Nov 1, , pm EDT. Oct 29, , pm EDT. Oct 28, , pm EDT. Edit Story. May 18, , pm EDT. Personal Finance. Follow me on Twitter. Viewing inflation across a more realistic 5-year timeframe shows just how high of a hurdle inflation poses for nominal yields.

The chart below outlines the real yields of different fixed income asset classes based on the current nominal yield minus the market implied rate of inflation over the next five years of 2. Real yields are a real problem for fixed income Nominal yields and real yields by sector.

Real rate represented by nominal yield-to-maturity minus the 5-yr inflation breakeven rate of 2. S Aggregate Bond Index. S MBS Index. High quality bonds such as Treasuries, mortgages, and investment grade corporates all result in strongly negative annual rates of real yield.

In order to gain any positive real yield, investors must look at lower quality holdings such as U. Clearly there are some hard choices ahead for bond investors. Doing nothing and staying in the safety of high quality bonds results in negative real yields. On the other hand, reaching out into lower credit quality securities like high yield and emerging market debt comes with higher default risk, more volatility, and potentially greater correlation to equities—all for a meager level of positive real yield.

Real rates are likely to remain low in the absence of a sudden growth surprise with some room to slowly rise as non-economic demand forces abate slightly. This strategy comes at the cost of sacrificing the safety of bond allocations and reduces diversification potential if equity markets sell off. As a global investment manager and fiduciary to our clients, our purpose at BlackRock is to help everyone experience financial well-being.

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