Monday, April 20, 2009

Can Inflation Save the Economy?

Greg Mankiw says yes. He talks about why cutting interest rates negative wouldn't work:
"So why shouldn’t the Fed just keep cutting interest rates? Why not lower the target interest rate to, say, negative 3 percent?

At that interest rate, you could borrow and spend $100 and repay $97 next year. This opportunity would surely generate more borrowing and aggregate demand.

The problem with negative interest rates, however, is quickly apparent: nobody would lend on those terms. Rather than giving your money to a borrower who promises a negative return, it would be better to stick the cash in your mattress. Because holding money promises a return of exactly zero, lenders cannot offer less."
And how obtaining negative interest rates might be possible through inflation:
"Suppose that, looking ahead, the Fed commits itself to producing significant inflation. In this case, while nominal interest rates could remain at zero, real interest rates — interest rates measured in purchasing power — could become negative. If people were confident that they could repay their zero-interest loans in devalued dollars, they would have significant incentive to borrow and spend."

Paul Krugman, however, says not yet.
"we’re talking about making a credible commitment to fairly high inflation over the medium term, yet you still have distinguished central bankers appalled at the Fed’s 2 percent inflation target."

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