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How low can they go?

Interest rates cannot become negative. Lenders, you can always earn a rate of zero percent by keeping your money in your pocket. You would never accept a negative rate.

But imagine what would happen if the expected rate of inflation happened to be a fairly large negative number. That is, what would happen if there were substantial deflation? According to the Fisher effect, the rate of interest would be negative unless the real rate of interest happened to be an even larger positive number. Remember to substitute the real rate of growth to help you think about the real rate of interest (you might also. Also, recall that the Fisher effect is that the nominal rate of interest, the rate we observe on credit contracts, is the sum of the real rate and the expected rate of inflation.

We have a problem here. We know that rates cannot be negative, but according to the Fisher effect they should be negative. What happens? Credit markets break down in a deflationary environment. Economic activity collapses as a result.

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