Should the interest rate will go zero in line with the Friedman rule and if the normal real interest rate aimed at 2 percent, inflation has to be -2 percent.

There is one subject I did not write about as it did not attract attention when it was raised: ‘Zero interest rate’. Today I would like to address it with a different perspective. ‘Zero interest rate’ is one of the debatable topics of monetary economics. It is generally covered as a sub-section in advanced monetary policy textbooks. The issue also has to do with the question “what is the optimal rate of inflation?” which I will raise today. Studies which aim to answer this question generally start with examining how interest rate can go zero. For example, Handbook of Monetary Economics (Elsevier, 2011) Volume 3 has a chapter titled “The Optimal Rate of Inflation.” The chapter was written by Schmitt-Grohe and Uribe, who are known for their works in monetary economics. In the section following the introduction, the study shows, using a highly technical model, how zero interest rate can emerge as an optimal solution in a market economy.

Cash money discouraged

‘Zero interest rate’ concept was first raised decades ago by Milton Friedman. Here is the economic background for the concept: Money (refers to cash money that does not earn any interest revenue, that is, banknotes and coins) has a certain utility for individuals. For example, if you have enough cash, you do not have to go to an ATM to get some goods from the groceries. I am neglecting the inconvenience when the ATM is out of cash or out of order. Or, when you are supposed to tip someone, you do not have to feel embarrassed for not having any cash on you.

We are talking about an important benefit, when you think of all individuals or companies, overall. The cost of issuing money however, is quite insignificant, at least in proportion to the social benefit it brings. On the other hand, higher the interest rate is, more you will be punished for holding cash money since you forego the interest revenue you would have earned if you had deposited the money at a bank. Here goes the argument: If we stop discouraging cash money, that is, if we cut interest rates to zero, economic efficiency will be enhanced. As I have mentioned above, this argument can be proved with highly technical models.

Prices have to be cut

But, one point must be regarded: The rate mentioned during the aforesaid studies is the nominal interest rate, not the real interest rate. It is claimed that, real interest rate should “normally” be between 2 and 4 percent when short-term volatilities are neglected and long term is taken into account (which we can read as the normal term). Here comes the link with inflation rate: you have to refer to the fact that interest rate is basically sum of inflation and real interest rate. If so, should the interest rate will go zero in line with the Friedman rule and if the normal real interest rate aimed at 2 percent, inflation has to be -2 percent, that is, deflation.

The aforementioned study, taking departure from this point, investigates why inflation rate generally floats around 2 percent in developed countries which implement inflation targeting regime and around 3 percent in developing countries. Please note that in this case, nominal interest rate corresponds to 4 percent with real interest rate at 2 percent and inflation at 2 percent. The study in this context tries to come up with a coherent reason why inflation rate is targeted around 2-3 percent rather than in the negatives as suggested by the rule for optimal interest rate at zero. One of the possible reasons addressed in the study gives an interesting insight about Turkey: If you are not able to collect sufficient tax revenue due to informality, you can collect the shortfall by creating inflation.

Anyway... For those who might ask why I addressed this subject today: This subject which sets the Thames on fire every time it is raised can also be discussed calmly with a different perspective. I thought it might be useful for us to realize this option.

This commentary was published in Radikal daily on 21.02.2012