ECN 204 Lecture Notes - Lecture 2: Nominal Interest Rate, Real Interest Rate, Royal Canadian Mint
Document Summary
Why not 0% inflation: zero lower bound on nominal interest rates: The nominal interest rate can not be negative, but the real interest rate approximately equal to the nominal interest rate minus the inflation rate can be. However, this is only true if there is some positive inflation; if inflation were 0%, the real interest rate could not be negative. With negative real interest rates, there is a strong incentive for people to spend and borrow rather than save, which is particularly important during a recession. Official inflation statistics tend to overstate the true rate of inflation (see topic 1). Thus, aiming for (official) inflation of 0% would imply that the true rate of inflation was actually negative. For psychological and contractual reasons, workers will strongly resist decreases in nominal wages. Accordingly, labour markets will not be able to smoothly adjust to downturns in the economy.
