Monetary policies and the leverage cycle without a zero lower bound for interest rates

Faculty Development Competitive Research Grants Program 2022-2024

Until recently, there has always been the presumption that the policy rates of central banks are constrained by the so called zero lower bound that supposedly forces nominal interest rates to be positive —the very idea of being paid (instead of having to pay) to borrow was considered utterly absurd. Notwithstanding, in the wake of the financial crisis in 2008 and the great recession that followed it, negative nominal interest rates have become, in an extremely unusual development, a policy instrument of central banks of major developed economies —Denmark, Switzerland, Sweden, the Bank of Japan, and the European Central Bank, as well as Hungary, have until now resorted to them— in an attempt to escape the liquidity trap implied by the ineffectiveness of a rates policy constrained by a zero lower bound. In spite of this major change in the policy framework, there is nonetheless surprisingly little research about the implications of negative interest rates for the wider economic policy and the economy in general. By aiming at addressing them, this project therefore stands out therefore for its novelty and significance. On the other hand, there is increasing evidence that the relaxation of lending constraints —by means of higher degrees of collateralization of purchased assets— plays, through the leverage cycle, a crucial role in the amplification of the business cycle, so that the latter cannot be effectively tackled by rates policies only. This aspect has nonetheless been unduly ignored in the debate on rates policies. The purpose of this project is thus to investigate (1) how does the effective absence of a zero lower bound for the rates policy affect monetary policy in general and its efficiency in particular, and (2) how does a rates policy without a zero lower bound interact with the leverage cycle. More specifically, the project focuses on questions like, among others,
(i) what is the optimal mix of rates policies and level of collateralization to stabilize the business cycle and sustain growth?
(ii) are there efficiency costs associated to a rates policy going below the zero lower bound, as negative rates distort the demand for cash and deposits?
(iii) what would be the pros and cons of a monetary reform towards a cashless economy to avoid this distortion?
(iv) what is the impact of taking rates below the zero lower bound on the stability of the financial and banking system and the leverage cycle?
Answers to these and other questions are likely to have a key impact on monetary policy design and, thus, on the ability to counter aggregate demand and supply shocks in order to keep the economy on an stable growth path. In the following sections, the previous research and current understanding of the issues raised above is presented, as well as the details of the project and the planned steps to develop it.