Chapter 34, Problem 4CYU

To determine

The reason why no one lend money at a negative nominal rate of interest and how it poses problems for monetary policy.

Explanation of Solution

When there is a negative nominal rate of interest, it is preferable for the lender to hold cash with a nominal rate of return of 0% because paying interest to the borrower (which is brought on by deflation) is probably absurd.

Furthermore, the projected deflation has an effect on the nominal interest rate because the equilibrium nominal interest rate will be lower than the initial interest rate. No one will therefore desire to lend money at a nominal interest rate that is negative.

Because the nominal rate of interest cannot be reduced to avoid falling into a liquidity trap, which would render monetary policy worthless, this creates issues for monetary policy. Additionally, once the nominal interest rate reaches the lower level, businesses and individuals will start to hoard their spare cash, preventing the interest rate from falling even further.

Economics Concept Introduction

Introduction: Inflation means there is increase in price of goods and services in the economy which affects the consumption level of the people in country. When there is temporary reduction in price inflation then this is a disinflation in economy. And, without considering inflation, the interest rate would be called nominal rate of interest.