Interest Rates

INTEREST RATES….Paul Krugman writes today about the prospect that the United States could fall into a liquidity trap, and makes this claim:

But what if the economy is in such a deep malaise that pushing interest rates all the way to zero isn’t enough to get the economy back to full employment? Then you’re in a liquidity trap: additional cash pumped into the economy ? added liquidity ? sits idle, because there’s no point in lending money out if you don’t receive any reward. And monetary policy loses its effectiveness.

This is standard stuff, of course: interest rates can’t go below zero. Thus, if interest rates are very close to zero, the Fed no longer has the ability to stimulate the economy by cutting them further.

Now, I know this is a really dumb question (and yes, contrary to popular wisdom, there is such a thing as a dumb question), but why is this so? Why can’t the Fed have negative interest rates? Walk up to the discount window, borrow a million dollars, and next month when it comes due you only have to pay back $900,000. Banks would then have an incentive to loan out this money at a negative rate too. As long as their rate was less negative than the Feds, they’d make money on the deal.

Needless to say, there have to be limits on how much a borrower is allowed to borrow under this system, and maybe that’s the fatal flaw. But are there others?

And once we have this taken care of, our next trick is to create interest rates that are multiples of the square root of -1….

UPDATE: In comments, Brad DeLong says we would have to put microchips in our money to make this work. Sign me up!

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