Can the Rate of Interest Ever Fall to Zero? | Macro Economics

Get the answer of: Can the Rate of Interest Ever Fall to Zero?

Sometimes the question is raised about the possibility of rate of interest being zero.

The answer is – it may be conceived in theory but is not likely to be zero in practice.

Let us take the most important theories and see what they tell us about it.

In the neoclassical loanable-funds theory, rate of interest is determined by the demand for and supply of capital which is also called loanable funds. As long as demand for capital is more than its supply, rate of interest will always be positive.

Some writers are of the opinion that as the standard of living of the people is rising in Western countries due to rising incomes and literacy, a stage may be reached in which people’s power and will to save will go up so much and their rate of discounting the future will go so down that the rate of capital accumulation will outstrip the demand for capital.

In their view, the supply of capital may become so plentiful as compared to the demand for it, as to reduce its marginal productivity to zero. But it is altogether improbable that such a stage may be reached. This is because the demand for capital is not likely to lag behind its supply and the supply price of capital is not likely to be zero either.

As for the demand for capital, it is likely to increase fast.

Firstly, population is increasing fast—at least in underdeveloped areas of the world. The demand for capital in the developing economies is vast.

Secondly, people’s tastes are changing so fast that the demand for capital in newer channels is not likely to cease.

Moreover, technical change is more likely to be capital-absorbing than capital-saving in nature. As a result of all these factors demand for capital is not likely to be such as to allow the rate of interest to fall to zero. Yet another factor which may keep the rate of interest positive is the premium which people will continue to place on the present rather than the future consumption.

On the supply side also we come to the conclusion that rate of interest cannot be zero. It is true that some people, by sheer force of habit or need, may save even at zero or negative rates of interest. But if the rate of interest is zero, the volume of saving forthcoming at the rate would be so low as to create acute scarcity of capital.

It would require a positive rate of interest to induce people to forego their present consumption of all their incomes to induce them to save enough to satisfy the demand for capital.

The conclusion then is that capital is not likely to lose its basic characteristic scarcity. Rate of interest as the allocative price for the services of capital and as the incentive to save and accumulate will continue to be positive.

Now come to the liquidity-preference theory. Keynes denied the possibility of reducing of the rate of interest to zero even by a vast supply of money by the monetary authority. Keynes believed that there is a low positive rate of interest at which the liquidity preference function (curve) is infinitely elastic, that is, at a low positive rate of interest, the liquidity preference curve becomes parallel to the horizontal (x) axis.

In other words, at a low positive rate of interest, the liquidity preference curve becomes infinitely interest-elastic. In other words, at a low positive rate there is what Keynes called a ‘liquidity trap’ people have an insatiable demand for money (a perfectly elastic demand for money with respect to the interest rate).

Even if the monetary authority goes on throwing huge stocks of money into circulation, the rate of interest would not fall below a certain positive rate, for at this rate, people simply go on absorbing the additional money into their money hoards.

The monetary experience of the days of the Great Depression also bears testimony to the conclusion of the impossibility of a zero rate of interest underlying Keynes’s liquidity trap hypothesis. Coming now to the determinate modern theory of the rate of interest, we find that rate of interest is one of the many equilibrating prices in the economy and is determined simultaneously with the level of income.

In this theory, the system as a whole determines the price called the rate of interest. If the price is negative or zero, it means costs of disposal or negative price for the things for which interest is paid. Such a state of affairs is not likely to prevail so long as it requires even the slightest effort to create a capital asset or even a little pain to forego the pleasure of immediately consuming one’s income.