Real Interest Rates & Economic Growth
This, some argue, is a problem because this limits the ability of the central bank to lower interest rates.
Greg Mankiw now proposes to fix that alleged problem. He starts by quoting a suggestion from one of his students that a year from now, the Fed would randomly pick a number and make all dollar bills with that number as its last serial number worthless, creating a negative expected return of -10% on dollar bills. That way, people would prefer to have their money in deposits even if those deposits had a negative interest rate of say 3%.
There are numerous practical problems associated with such a scheme, but perhaps they can be resolved or limited. The same goes for the similar scheme by Silvio Gesell to tax cash holdings.
And the trouble of people moving to hold more gold and similar real assets could perhaps be resolved in the way FDR solved it: by banning people from investing in them.
Perhaps a more fundamental flaw in the scheme is that it presumes that lower real interest rates are always beneficial for the economy. That may be the assumption in the kind of New Keynesian models used by Mankiw, but in reality lower real interest rates is a symptom of the phenomena’s which are beneficial to the economy.
Lower real interest rates in a pure market economy, or simply an economy with a stable money supply, would be the result of lower time preferences, or in other words a higher willingness to save. That will boost investments and so also increase productive capacity.
If we instead assume that the decline in real interest rates was the result of monetary inflation, then it can too provide a short-term boost to the economy, provided certain assumptions specified in the Austrian business cycle theory holds true.
But under other circumstances, lower real interest rates will not boost the economy even in the short-term. If no entrepreneur is willing to invest despite negative real interest rates, then the decrease in money demand will simply lead to higher prices, something which causes money demand to simply fall further, which in turn leads to yet higher prices in a hyperinflationary spiral. Countries with hyperinflation have strongly negative real interest rates, and are thus the perfect example of what happens if such schemes are initiated.
This will do nothing to boost output even in the short-term and will have disastrous consequences later as there will either be a breakdown of the monetary system through hyperinflation like in Germany in 1923 or a severe contraction when monetary authorities in order to stop the hyperinflationary spiral must iniate a sudden, dramatic monetary contraction.