Monetary Policy and Zero Rates, A Thought Experiment

As always when I think about money and interest rates, I'd like to start with the Fisher equation, which says the nominal interest rate is equal to the real interest rate plus expected inflation. Lets imagine that in a closed economy, the market for loanable funds clears at a 5% real rate of interest, and the money supply is expected to grow 5% while real output grows 3%, giving 2% inflation. The nominal interest rate observed in credit markets would then be 7%. Simple enough. At a 7% nominal interest rate no one would argue that the monetary authority could "cut" interest rates by buying bonds, hence raising their price and lowering their yields. That's because the expansionary stance of policy (5% money growth) has kept them decisively positive, thus giving the impression that their is room to be "more" expansionary. At the margin, the central bank can exchange non-interest bearing  base money for interest bearing bills, altering the portfolio structutre of the economy and temporarily lowering short-term rates (before the increased money supply pushes up nominal spending and prices and financial markets price in the increase in inflation.)

But let's imagine a scenario where the stance of policy is not expansionary, but contractionary. Let's say the money supply is growing at 2% per year, real output at 1%, but the income elasticity of demand for base money is more than unity so that it rises 2% for a 1% rise in income. This gives us a -1% rate of inflation, or a 1% rate of deflation even though the money supply is growing at 2%. Now let's say weak growth has depressed the demand for loanable funds and households and businesses are saving more so the equilibrium real interest rate has collapsed to one percent. Going back to the Fisher equation, this means the nominal interest rate in the short-term money market is...zero. By standard Keynesian monetary theory, we are in a liquidity trap, and the central bank is out of ammo. On the margin, bonds and money are perfect substitutes, so expanding the money supply will do nothing.

The implication of this is that all the hemming and hawing about how monetary policy is ineffective when nominal rates are zero has bizarre implications. When money has been loose, the thinking goes, more expansion will have traction. When money has been tight and the economy is weak, expansionary policy will do nothing. I don't buy it. 

I Did Not Know This, Fun Fact Edition

This was something of which I was not previously aware. Americans probably think (as I did before today) that the American flag is a unique design, or at most derived or inspired from something else. But no.  Its pretty much the same flag that has been around since 1599 (on the left).

In case you did not recognize it, thats the flag of theBritish English East India Company, chartered by Queen Liz in 1599. This was the design from that date until 1707, when Scotland and England merged to become the Kingdom of Great Britain. Henceforth, the Company flag looked like the one on the right.  (okay not entirely true, that one includes the cross of St. Patrick, included after 1801). 
If you like counting, feel free to count how many stripes are on that bad boy. Thats right. 13. So much for the "13 stripes for 13 colonies" thing. More like a big convenient coincidence. And yes, this is the same East India Company that was granted the monopoly on tea in the colonies that was the impetus for the famous Boston Tea Party. The early patriots not only stole the Company's tea, they also stole the flag. Burn.                          
"I pledge alliegence to the flag, of the Company of Merchants Trading into the East Indies, and to the Corporation, for which it stands, one entity, by charter of Her Majesty, indivisible, with tea, indigo, and opium for all."

Cartoon Time, Economics Edition

Paul Krugman on Monetary Policy at the ZLB

"The standard answer goes like this: interest rates are already very low, so the Bank of Japan has done all it can. Meanwhile, the government has a severe fiscal problem, so it cannot increase spending or cut taxes. There is, in short, nothing to be done except pursue structural reforms and hope for an eventual turnaround. This answer sounds hard-headed and responsible. In fact, however, it is based on a completely false premise - the idea that the Bank of Japan has reached the limits of what it can do.
The simple fact is that there is no limit on how much a central bank can increase the supply of money. Could the Bank of Japan, for example, double the amount of monetary base - that is, bank reserves plus cash in circulation - over the next year? Sure: just buy that amount of Japanese government debt. True, even such a large increase in the money supply might not drive down interest rates very much, since they are already so low. But an increase in Japan's money supply could ease the economic problem in ways other than lower interest rates. It is possible that putting more cash in circulation will stimulate spending directly - that the extra money will simply "burn holes in peoples' pockets". Or banks, awash in reserves, might become more willing to lend; or individuals, with all that cash on hand, will bypass the banks and find other ways of investing."

But this was written in the mid 1990s. And about Japan. So I guess the rules are different or something.