So far this recession has been a boon to those of us who teach intermediate macroeconomics. We're covering all the theoretical possibilities we were only able to speculate about in the past.

For instance, yesterday the Fed lowered their target interest rate to essentially zero. The idea of this is to lower the cost of borrowing so that banks can borrow cheaply and then lend that money out to firms and people to buy stuff. But the Fed has been lowering the interest rate for months and the economy continues to worsen. And now the Fed has no place left to go - you can't lower the interest rate to less than zero.

So why isn't the lower Fed interest rate working? And if it isn't working, what is the Fed's next step? To answer this, let's review something really important, the Fisher equation (thanks Irv!).

Nominal interest rates (the rate you pay on your mortgage is a nominal interest rate) is made up of two parts:

i = r + p

where i is the nominal rate, r is the real interest rate, and p is a measure of inflation. To understand this definition, think about lending me some money. If you are going to loan me $1000, you need to be compensated for two things. First, you need a 'real' return - this refers to the fact that for a year (or however long it takes me to pay you back) you will *not* have $1000. The real interest rate is the 'charge' for this inconvenience to you. Let's say that is equivalent to 3%. That is, the cost of not having your $1000 for a year is $30.

In addition to paying you the real return, I need to compensate you for the fact that a year from now prices will likely be higher. So when I pay back the $1000, you can buy less stuff than you could have today. Thus I have to pay you something in addition to the real return. That something is the inflation rate. If inflation were 2%, then the nominal rate would be 3% + 2% = 5%.

The Fed targets the nominal interest rate. By saying that they have an interest rate target of 0%, they are saying that:

r + p = 0

Now, why might this not stimulate the economy? Well, if we have that inflation is negative (deflation), then p<0 and it has to be that r>0. If we expect prices to fall by 3% over the coming year, then the real rate of interest is equal to +3%. The *real* interest rate is what matters for investment in the economy. So even though nominal rates of interest are zero, because of deflation this might mean that real interest rates are quite large.

Given the recent CPI information, it seems that prices are falling or stagnant, and more importantly, it seems that people are expecting prices to fall in the future. Therefore the real interest rate is positive and large, and firms don't want to borrow.

So now what does the Fed do, if they can't lower the nominal rate below zero? Well, they can try and adjust the expected inflation rate. How do they do that? Fire up the presses. We are at the point where the Fed will likely need to start printing money, and use this money to buy up financial assets. The flood of new dollars into the banking system will drive up inflation. More importantly, the Fed will have to convince everyone that they intend to keep inflation up (say at around 3%) for the foreseeable future.

If inflation is +3%, and the nominal rate of interest is 0%, then the real rate of interest is -3%. Now we're cooking (we hope). Negative real interest rates mean that you actually make real money by borrowing. Firms will be better off borrowing to buy new machines and expand production *now*, rather than in the future.

Ultimately, yesterdays setting of the nominal interest rate to zero signals that we are done with interest rate policy for the next year or so. The Fed will have to move on to adjusting inflation directly to achieve any stimulus at all.

This is not the end of the world, but it is like the guys at the Alamo running out of ammuntion and chucking rocks and dead cats at the Mexicans. The Fed is down to dead cat throwing. Well placed dead cats can still kill a man (I would presume that you need to get the claws to stay out, maybe if rigor sets in you can make this work), so it is not like they are powerless. But much of the emphasis will likely now shift to the fiscal stimulus plan.

## Wednesday, December 17, 2008

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