Question

6. a. b. Answer this question based on the Fisher equation and Fisher effect During the period of deflation, what could have happened to the nominal interest rate according to the Fisher effect? Practically, nominal interest rates rarely drop to a negative value, Explain how a deflation may possibly affect real interest rates. Use this to explain why Europe's central banks cut key interest rates below zero in 2014. Discuss its effectiveness in the long run. c.

Answer 1

a) Fisher Effect tells that

Real interest rate = Nominal interest rate - Expected rate of inflation.

Therefore, nominal interest rate during the period of deflation according to fisher effect falls toward zero when the expected rate of deflation is increasing.

b) For the case of real interest rate during the period of deflation the real interest rate will increase with the decrease in inflation.

c) The reason behind central banks to cut interest rate below zero is, to maintain the cost of holding central bank reserves. Another reason of maintaining zero interest rate is to monitor the role of inflation targeting to set up price competitive mechanism.

The effectiveness in the long run was that some central banks resumed purchasing the bonds and also expanded its assets with respect to government bonds and other asset securities. Another long term effect was the stabilisation of currency of many foreign countries. Another effect was the central banks reviewed its IT systems and accounting rules.