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This term has been proposed in economics, what exactly is it? I thought interest rates never fall below zero. How would this work? Wouldn't it actually be a penalty to depositor/investor or a bonus to the someone with a loan or mortgage?

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up vote 7 down vote accepted

Negative interest rates already exist. Like the after tax real interest rate on US T-bills has been negative for 60 years (Refer to A Negative Equilibrium Interest Rate, by Moshe Levy, Haim Levy and Avi Edry).

And in periods of price inflation, of course, the monetary base is under a real negative interest rate, as well as assets with "too low" nominal interest rates.

Many economists like Paul Krugman, Greg Mankiw and Willem Buiter recently mentioned that the equlibrium interest rate also currently is negative and even a nominal 0% is not sensible at all. E.g. here: Negative interest rates: when are they coming to a central bank near you?

Further, even if the the real interest rate is negative, it still can be too high! Too high meaning that it could still be above the equilibrium interest rate if that is even deeper negative.

How the equilibrium interest rate can be negative is easy to imagine: Credit is basically intertemporal trade. And the interest rate is the price for intertemporal trade. If more people want to save money for their retirement then people want (and can!) borrow for the current interest rate, then the interest rate has to drop. And if even at 0% more people want to save money, the interest rate has to fall below 0% to reach equilibrium.

The limit is the interest rate on the monetary base, which cannot go below nominally 0%. Actually, only cash is a problem, as you could not force anyone to receive the negative interest (which means: pay for keeping cash).

As long as the only way is price inflation, it unfortunately always means more indeptness. If no one else can, the governments have to. Thats always the problem with minimum price guarantees: Either the governments have to force someone to pay the lifted price or the government has to pay it themselves.

All this is taught to economic students in the first two years. Just that almost no one applies such simple market mechanisms to money. Instead most economists think that money is just a measure. Thanks to Krugman, Mankiw and Buiter and some others to start breaking this error.

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Hi Michael! Welcome. Great answer. +1. (I fixed the links for you; sorry about the new user limitation!) –  Chris W. Rea Dec 16 '09 at 12:49
    
+1 Great answer Michael! –  Zephyr Dec 16 '09 at 16:41
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