Effective Lower Bound
By the assumption made by many standard textbooks and models, zero is the lower bound of an interest rate, limiting the central bank's capacity to stimulate the economy through monetary policy loosening. This assumption has been disputed recently, as central banks of several countries have set interest rates at negative levels.
Some economists tried to identify (at least theoretically) the interest rate which is, indeed, a lower bound for expansionary monetary policy. They have found that for an interest rate below some (probably negative) level, the further decrease may surprisingly be contractionary. This task will walk you through their reasoning.
(a) (5 rp) Explain why zero is sometimes considered the lower bound of an interest rate.
Keeping paper currency can always bring 0 interest rate.That's why, if nominal interest rates are negative, people will hold cash instead of keeping money in banks, so lowering the interest rate further would not stimulate spending.
(b) (5 rp) Decreased interest rates lead to capital gains on securities owned by banks, improving their capital position. Explain this phenomenon.
The prices (and present values) of assets are inversely related to interest rates. So, if the rate goes down, the securities owned by a bank increase in prices.
(c) (10 rp) On the other hand, there is some evidence that when the interest rates go down because of the central bank's decision, commercial banks' net interest margins narrow, causing profitability decline. Explain why this might be the case.
Banks net interest margins equal the difference between the lending and the borrowing rate. The pass-through of the policy rate to market rates is imperfect because of the stickiness of deposit rates. Banks are competing with one another, so they will be reluctant to decrease deposit rates in fear of losing their customers. Thus, the credit rates decline to a greater extent than deposit rates, causing the margins to shrink.
(d) (10 rp) If the decline of today's value of future profits outweighs the capital gains, the bank's overall capital position deteriorates. Explain how this may lead to less lending by a bank, making the "stimulus" contractionary.
If capital position deteriorates, banks need more high quality liquid assets (government bonds, cash) and less loan portfolio because it is not a high quality liquid asset. It is regulated by capital requirements regulation (Basel III). This may cause a decrease in lending.
Comment. The idea of 'reversal interest rate' was first expressed by Markus K. Brunnermeier & Yann Koby in 2018. They present a theoretical model of how the effect of interest rate decreasing may reverse, but convincing empirical evidence of such phenomenon is still missing. For popular (ant critical) discussion of the matter, see https://www.ft.com/content/ 3dbca034-df7f-11e9-9743-db5a370481bc and https://voxeu.org/article/reversal-interest-rate-critical-review.