The Impact of Negative Interest Rates on the Eurozone

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The Impact Of Negative Interest Rates On The Eurozone I pledge my honour that I have not violated the Booth Honour Code in the preparation of this case. Signed: Hicham Talebali Weighing the Argument There are two key pay-offs in sanctioning negative interest rates. On the one hand, negative rates would loosen credit and may solve the Eurozone’s deflation issues. On the other hand, we have a real danger of the Japanisation of the Eurozone. Loosening of Credit Proponents of negative interest rates suggest that when financial intermediaries choose between paying for deposits and receiving income from loans, they will choose the latter. In turn, businesses benefit from this greater amount of credit. Japanisation of the Eurozone However, we mustn’t lose sight of why this proposal is being mooted – to stave off the Eurozone’s deflationary issue. As such, will negative interest rates stem the tide? The answer to this question is simply not clear, but it primarily depends upon expectations of future inflation. That is, spending in the current period is unattractive unless prices are expected to rise. Figure [ 1 ]. A Possible Liquidity Trap (credit: Krugman). Figure [ 1 ]. A Possible Liquidity Trap (credit: Krugman). There is a grave danger, therefore, of a liquidity trap for the Eurozone. If indeed, banks do not lend to businesses (because of the expectations stated previous) and instead invest in capital markets (i.e. spending in the economy does not increase), we have some dangerous ramifications. Assuming that negative interest rates is a way of “unlocking” money supply, then the shift from AD to AD’ is clear (up, but not to the right). As such, the ECB runs the risk that its monetary policy no longer being effective, effectively replicating Japan’s “lost decade”. Recommendation The Author believes that negative real interest rates in
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