In recent decades central banks have responded to recessions with cuts to their lending rates of around five percentage points. The usual pattern has been that when the economy recovers and inflation increases, the central bank has raised interest rates, and so recovered its capacity to respond to the next recession. This pattern was not followed after the Global Financial Crisis (2007-2009). Instead, inflation remained stubbornly low, and so there was been no scope for central banks to raise interest rates. There is now concern that central banks have no capacity to respond to the next (possibly current) recession.

An option that has been proposed is for central banks to charge negative nominal interest rates on bank deposits. While this idea has some practical problems (like people hoarding bank notes), the more important issue it to work out theoretically the likely impact of negative policy interest rates. You can read a case for and against negative interest rates here and here.

In answering the following, assume that there is no fiscal response.

1.Briefly explain the idea of a liquidity trap.

2.Use the IS-LM model to construct an example showing a situation where a central bank would like to set a negative nominal interest rate. Explain the implications of not allowing a negative nominal interest rate in the short run.

3.Following from 2., what would be the implications in the medium run of the central bank not being able to return unemployment to its natural rate with nonnegative interest rates. Use the expectations augmented Phillips curve in preparing your answer.

From the perspective of the short- and medium-run versions of the IS-LM model, does it make sense for central banks to consider negative nominal interest rates? From your reading of Stephen Roach's article (linked above), what other concerns might you have about negative nominal interest rates?