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Negative Nominal Interest Rates Can Worsen Liquidity Traps

Andy Glover

No RWP 19-7, Research Working Paper from Federal Reserve Bank of Kansas City

Abstract: Can central banks use negative nominal interest rates to overcome the adverse effects of the zero lower bound? I show that negative rates are likely to be counterproductive in an expectations-driven liquidity trap. In a liquidity trap, firms expect low demand and cut prices, which leads the central bank to reduce nominal rates to their lower bound. If the resulting decline in real rates is not enough to stabilize demand, then the pessimism of price setters is fulfilled. Theoretically, the effect of a negative nominal rate is non-monotonic: a marginally negative rate is not enough to escape the liquidity trap, but allows for more pessimistic expectations and deflation, while a sufficiently negative rate eliminates the trap altogether. However, plausible estimates of the cost and benefits of price adjustments in the U.S. suggest that negative rates are contractionary in a liquidity trap, even at ?100 percent.

Keywords: Interest Rates; Nominal Negative Rates; Liquidity Traps (search for similar items in EconPapers)
JEL-codes: E50 E52 E58 (search for similar items in EconPapers)
Pages: 21 pages
Date: 2019-10-03
New Economics Papers: this item is included in nep-cba, nep-mac and nep-mon
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DOI: 10.18651/RWP2019-07

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