Principles of Macroeconomics / Unit 12 MAC 1134 worked example, 60 to 90 seconds
Real Rates and the Zero Lower Bound
The idea
Compute the real interest rate from the nominal rate and inflation, then apply it to deflation. Unit six gave the relationship: the real rate is the nominal rate minus inflation. What this entry adds is what happens when inflation turns negative and the nominal rate cannot.
In practice
A nominal rate of 3 percent with inflation of 1 percent gives a real rate of 2 percent. Cut the nominal rate to 1 percent and the real rate falls to zero, which is stimulative. Now let prices fall by 2 percent a year with the nominal rate already at zero. The real rate is zero minus negative 2, which is positive 2 percent. The central bank has cut as far as it can and the real rate has risen. Holding cash now earns 2 percent in real terms for doing nothing.
Where people slip
This is the zero lower bound, and it inverts the usual picture: the more prices fall, the tighter policy becomes, however loose it looks. Nominal rates stop at zero because nobody lends ten dollars to get back less than ten. Deflation is not automatically catastrophic, and the United States grew through a long deflation in the late nineteenth century, but deflation with a nominal rate already at zero disables the main tool.
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