What Lower Bound? Monetary Policy with Negative Interest Rates*
Policymakers and academics have long maintained that nominal interest rates face a zero lower bound (ZLB) which can only be breached through major institutional changes like the elimination or taxation of paper currency. Recently, several central banks have set interest rates as low as 0.75% without any such changes, suggesting that, in practice, money demand remains finite even at negative nominal rates. I study optimal monetary policy in this new environment, exploring the central tradeoff: negative rates help stabilize aggregate demand, but at the cost of an inefficient subsidy to paper currency. Near 0% the first side of this tradeoff dominates, and negative rates are generically optimal whenever output averages below its efficient level. In a benchmark scenario, breaking the ZLB with negative rates is sufficient to undo most welfare losses relative to the first best. More generally, the gains from negative rates depend inversely on the level and elasticity of currency demand. Credible commitment by the central bank is essential to implementing optimal policy, which backloads the most negative rates. My results imply that the option to set negative nominal rates lowers the optimal long run inflation target, and that abolishing paper currency is only optimal when currency demand is highly elastic. *I am deeply grateful to my advisors Ivan Werning, Daron Acemoglu, and Alp Simsek for their continual guidance and support, and to Adrien Auclert for invaluable advice on all aspects of this project. I also thank Alex Bartik, Vivek Bhattacharya, Nicolas Caramp, Yan Ji, Ernest Liu, Miles Kimball, Ben Moll, Emi Nakamura, Christina Patterson, Jon Steinsson, and Ludwig Straub for helpful comments. Thanks to the NSF Graduate Research Fellowship for financial support. All errors are my own. +Northwestern University and Princeton University.