Talk of the zero lower bound has permeated the debate about monetary policy in recent years. In particular, there is one consistent story across a variety of different thinkers involving the difference between the natural rate of interest and the market rate of interest. Specifically, the argument holds that if the market rate of interest is higher than the natural rate of interest then monetary policy is too tight. With regards to the current state of the world, this is potentially problematic is the market rate of interest is zero, but needs to be lower.

I find this way of thinking about monetary policy to be quite odd for several reasons. First, conceivably when one talks about the natural rate of interest, the reference is to a real interest rate. New Keynesians, for example, clearly see the natural rate of interest as a real rate of interest (at least in their models). Second, the market rate of interest is a nominal rate. Thus, it is odd to say that the market rate of interest is above the natural rate of interest when one is nominal and one is real. I suppose that what they mean is that given the nominal interest rate and given the expectations of inflation, the implied real market rate is too high. But this seems to be an odd way to describe what is going on.

Regardless of this confusion, what advocates of this approach appear to be saying is this: when the market rate of interest is at the zero lower bound and the natural rate of interest is negative, unless inflation expectations rise, there is no way to equate the real market rate of interest with the natural rate.

But this brings me to the most important question that I have about this entire argument: Why is the natural rate of interest negative?

It is easy to imagine a real market interest rate being negative. If inflation expectations are positive and policymakers drive a nominal interest rate low enough, then the implied real interest rate is negative. It is NOT, however, easy to imagine the natural rate of interest being negative.

To simplify matters, let’s consider a world with zero inflation. The central bank uses an interest rate rule to set monetary policy. The nominal market rate is therefore equal to the real market interest rate. Thus, assuming that the central bank is pursuing a policy to maintain zero inflation, they are effectively setting the real rate of interest. Thus, the optimal policy is to set the interest rate equal to the natural interest rate. Also, since everyone knows the central bank will never create inflation, this makes the zero lower bound impenetrable (i.e. you cannot even use inflation expectations to lower the real rate when the nominal rate hits zero). I have therefore created a world in which a central bank is incapable of setting the market rate of interest equal to the natural rate of interest if the natural rate is negative. My question is, why in the world would we ever reach this point?

So let’s consider the determination of the natural rate of interest. I will define the natural rate of interest as the real rate of interest that would result with perfect markets, perfect information, and perfectly flexible prices (the New Keynesian would be proud, I think). To determine the equilibrium real interest rate, we need to understand saving behavior and we need to understand investment behavior. The equilibrium interest rate is then determined by the market in our perfect benchmark world. So let’s set up a really simple model of saving and investment.

Time is continuous and infinite. A representative household receives an endowment of income, y, and can either consume the income or save it. If they save it, they earn a real interest rate, r. The household generates utility via consumption. The household utility function is given as

where is the rate of time preference and is consumption. The household’s asset holdings evolve according to:

where are the asset holdings of the individual. In a steady state equilibrium, it is straightforward to show that

The real interest rate is equal to the rate of time preference.

Now let’s consider the firm. Firms face an investment decision. Let’s suppose for simplicity that the firm produces bacon. We can then think of the firm as facing a duration problem. They purchase a pig at birth and they raise the pig. The firm then has to decide how long to wait until they slaughter the pig to make the bacon. Suppose that the duration of investment is given as . The production of bacon is given by the production function:

where f’,-f”>0 and b is the quantity of bacon produced. The purchase of the pig requires some initial outlay of investment, , which is assumed to be exogenously fixed in real terms and then it just grows until it is slaughtered. The value of the pig over the duration of the investment is given as

Integration of this expression yields

Let’s normalize the amount of investment done to 1. Thus, we can write the firm’s profit equation as

The firm’s profit-maximizing decision is therefore given as

Given that the firm makes zero economic profits, it is straightforward to show that

So let’s summarize what we have. We have an inverse supply of saving curve that is given as

Thus, the saving curve is a horizontal line at the rate of time preference.

The inverse investment demand curve is given as

The intersection of these two curves determine the equilibrium real interest rate and the equilibrium duration of investment. Since the supply curve is horizontal, the real interest rate is always equal to the rate of time preference. So this brings me back to my question: How can we explain why the natural rate of interest would be negative?

You might look at the equilibrium conditions and think “sure the natural rate of interest can be negative, we just have to assume that the rate of time preference is negative.” While, this might mathematically be true, it would seem to imply that people value the future more than the present. Does anybody believe that to be true? Are we really to believe that the the zero lower bound is a problem because the general public’s preferences change such that they suddenly value the future more than the present?

But suppose you are willing to believe this. Suppose you think it is perfectly reasonable to assume that people woke up sometime during the recession and their rate of time preference was negative. There are two sides to the market. So what would happen to the duration of investment if the real interest rate was negative? From our inverse investment demand curve, we see that the real interest rate is equal to the ratio of the marginal product of duration over total production. We have made the standard assumption that the marginal product is positive, so this would seem to rule out any equilibrium in which the real interest rate was negative. But suppose at a sufficiently long duration, the marginal product is negative. We could always write down a production function with this characteristic, but how generalizable would this production function be? And why would a firm choose this actually duration when they could have chosen a shorter duration and had the same level of production?

Thus, the only way that one can believe that the natural rate of interest is negative is if they believe that individuals suddenly value the future more than the present and that in a perfect, frictionless world firms would prefer to undertake dynamically inefficient investment projects. And not only that, advocates of this viewpoint also think that the problem with policy is that we cannot use our policy tools to get us to a point consistent with these conditions!

Finally, you might argue that I have simply cherry-picked a model that fits my conclusion. But the model I have presented here is just Hirshleifer’s attempt to model the theories of Bohm-Bawerk and Wicksell, the economists that came up with the idea of the natural rate of interest. So this would seem to be a good starting point for analysis.

P.S. If you are interested in evaluating monetary policy within a framework like this, you should check out one of my working papers, written with Alex Salter.