Write 2 paragraphs about "The causes and challenges of low interest rates: insights from basic principles and recent literature" article. 250 max word count, not formatting requirements. Alternate title: Causes and challenges of low interest rates

Wu, Youchang. China Finance Review International; Beijing Vol. 11, Iss. 2, (2021): 145-169. DOI:10.1108/CFRI-06-2020-0071 Purpose What causes the downward trend of real interest rates in major developed economies since the 1980s? What are the challenges of the near-zero interest and inflation rates for monetary policy? What can the policymakers learn from the latest developments in the monetary and interest rate theory? This paper aims to answer these questions by reviewing both basic principles of interest rate determination and recent academic and policy debates. 1. Introduction There is a significant decline in real interest rates, defined as nominal rates minus expected inflation rates, in major developed economies since the 1980s. Panel (a) of Figure 1 plots the real and nominal 1-year treasury rates in the US from January 1980 to April 2020 and the real 10-year rates measured by the yield on the US Treasury Inflation-Protected Securities (TIPSs) since 2003. The downward trend is pronounced. The nominal 1-year rate declines from the peak of 16.7% per annum in August 1981 to 0.18% in April 2020, while the real 1-year rate drops from 6.9% to 2.2%. From August 2007 (the month marking the start of a series of rate cuts by the Federal Reserve System in response to the worsening subprime mortgage crisis) to the sample end, the average 1-year rate is 0.89% in nominal terms and 1.43% in real terms, while the average real 10-year rate is 0.66% per annum [1]. The secular decline of real interest rates is a global phenomenon. In fact, interest rates have been lower in many other developed countries than in the US since the 2008 financial crisis. In Japan, Switzerland and many European Union countries, even nominal interest rates have been in the negative territory in recent years. In particular, the current German government bond yields are negative for all maturities up to 30 years. Negative nominal interest rates are not only observed in government bonds. Panel (b) of Figure 1 shows the nominal 3-month London Interbank Lending Rates (LIBOR) for the euro, British pound, Japanese yuan and Swiss franc. Among them only the rate for the British pound remains above zero at the sample end. Yi and Zhang (2017) examine real interest rates in the 20 largest economies from (up to) 1955 to 2014 and document a steady decline and convergence across countries since late 1980s. This pronounced downward trend of real interest rates in over three decades and the persistent low interest rates in recent years have posed many theoretical and practical questions. What causes the downward trend? What are the challenges of the near-zero interest and inflation rates for monetary policy? And what can the policymakers learn from the latest developments in the monetary and interest rate theory? This paper aims to answer these questions by reviewing both basic principles of interest rate determination and recent academic and policy debates. The canonical models of the neoclassical asset pricing and growth theory point to productivity growth, risk, and population growth as the main determinants of real interest rates, in addition to the subjective discount factor. Recent studies have examined the role of these factors in depth as well as factors beyond these models, including convenience yields of safe assets, global demand for safe assets, relative price of capital, wealth and income inequality, and monetary policy. I review the explanations based on these factors and discuss their merits and limitations. While recognizing the relevance of each of these factors, I emphasize the importance of a better understanding of economic forces leading to a downward trend in corporate investment and an upward trend in corporate saving. The near-zero nominal interest rate limits the space of central banks' response to economic crises. A series of unconventional monetary policies have been experimented following the global financial crisis in 2008, including quantitative easing, forward interest rate guidance, and negative interest rates. More aggressive actions have been taken upon the outbreak of the COVID-19 pandemic. While the monetary policies post the 2008 crisis have been successful in maintaining the stability of the financial system, they do not appear to be very effective in boosting aggregate demand and growth. In fact, most central banks consistently undershoot their inflation targets. These experiences and challenges have spurred or generated renewed interest in unconventional ideas of monetary theory, including the new Fisherism and the fiscal theory of price level. The last part of this review discusses the monetary policy conundrum in the near-zero interest rate environment and the policy implications of these new developments in monetary theory. The literature on the low real interest rate is vast, and it is growing at a fast pace. Therefore, this is by no means a complete survey. Several papers and commentaries provide an overview of the topic. Summers (2014) discusses a list of potential contributing factors to the decline. He revives the term "secular stagnation" first introduced by Alvin Hansen and uses it as an overarching concept to describe the current prolong situation of low demand, low growth and low interest rates. Hall (2017a) discusses the causes and consequences of low interest rates. The US Council of Economic Advisors (2015) reviews the world-wide decline of long-term interest rates and discusses potential reasons. Rachel and Smith (2017) examine quantitatively the contributions of various factors to the shifting of global investment and saving schedules. This survey differs from the existing work by taking a broader view of both economics and finance literature and by critically reviewing of each proposed explanation and policy recommendation through the lens of basic principles and empirical evidence. The review is structured as follows. Section 2 reviews the standard neoclassical theory of real interest rate determination. Section 3 reviews the recent findings on causes of the secular decline. Section 4 discusses the challenges of low interest rates for monetary policy and the policy implications of the neo-Fisherism and the fiscal theory of price level. Section 5 concludes with a short summary. 2. The determination of real risk-free rates: basic principles In this section, I review the determination of real risk-free rates in the standard consumption-based asset pricing theory and neoclassical growth theory. Following the tradition of the "classical dichotomy," which maintains that real variables such as the real interest rate are determined only by real factors and not by monetary factors, these standard theories abstract from potential influences of monetary policy. While the canonical models reviewed here leave out many important drivers of real interest rates, they highlight the key mechanisms and provide a foundation for models with more realistic features. The closed-form results they offer provide transparency and clarity often unavailable from the more sophisticated models in modern literature. 5. Conclusion It is now time to conclude this somewhat long intellectual journey in the theory and reality of the real interest rate. What are the main takeaways from this journey? The neoclassical asset pricing theory and growth theory provide a useful framework for understanding the downward trend of real interest rates. The canonical models suggest that the risk-free interest rate is determined by the subjective discount factor, the expected consumption/productivity growth, the riskiness of the consumption/productivity growth, and the population growth. It also suggests that a negative real interest rate can arise naturally when the expected growth rate is low and when the risk is large. These predictions are helpful for understanding the downward trend. The decline coincides with a slowdown of productivity growth since the 1970s. However, recent studies only find a tenuous long-run correlation between the real risk-free rate and productivity growth. In addition, the real return on productive assets has been stable in recent decades. These findings suggest that slow productivity growth may not be the reason for the secular decline of the real interest rate. The negative effects of some demographic trends, including lower population growth, lower fertility rate, increased longevity, have received stronger empirical support. Nevertheless, the quantitative importance of these demographic trends needs to be assessed with caution, given that these trends coincide with a sharp decline in the personal saving rate and a diminished share of households' contribution to the aggregate saving of the economy. Elevated tail-risk concerns, together with large convenience yields of government bonds during extreme events, provide a credible explanation for the decline of real interest rate after the 2008 financial crisis. Since agents do not know the true shock distribution, extreme events such as the 2008 crisis and the 2020 pandemic can have a long-lasting effect on the perceived tail-event probability. Tail-risk concerns may also have contributed to the increased demand for safe assets of developed countries after the financial crises in emerging markets in the 1990s. Factors beyond the standard theory also help to explain the interest rate decline. These include the increased global demand for safe assets of developed countries, the accommodative monetary policy, the falling relative price of capital, and the rising wealth/income inequality. The convenience yields of safe assets provide an explanation for negative nominal risk-free rates in Japan and Europe. Given the large increase in corporate saving relative to corporate investment in recent decades, a better understanding of economic forces driving the diverging trends of corporate investment and saving behaviors should be very helpful for understanding the trend of the real interest rate. A critical review of each explanation put forward in the literature suggests that each explanation has its merits, but none of them provides a full qualitative and quantitative account of the real interest rate dynamics in recent decades. It is plausible that the secular decline of the interest rate is a joint outcome of most if not all the factors mentioned above. Furthermore, since most of these factors represent relatively slow evolution of the real economy without a clear sign of reversal in the near future, the low real risk-free rate is likely to persist for some considerable time. The low interest rate poses a conundrum for monetary policy as it limits the space for rate cuts in response to potential crises. Even if a negative nominal rate is theoretically justifiable and technically feasible, it is not necessarily stimulating. Due to its negative impact on banks' net worth, a low interest rate can reverse to become contractionary. Importantly, this reversal rate is not necessarily negative. The low interest rate and low inflation economy also push economists to rethink the fundamental principles of monetary theory. The neo-Fisherist view of the monetary policy argues that the conventional Taylor rule-based policy has a tendency of falling into the liquidity trap. A radical policy recommendation coming out of this theory is that in order to break the liquidity trap central banks should increase instead of decreasing the nominal interest rate. If the prevailing interest rate is below the reversal rate, then a rate increase can indeed be stimulating. Unconventional monetary policies like this should be evaluated with caution as there may be unintended consequences. Quantitative estimation of the reversal rate such as done by Wang et al. (2019) is very useful for this purpose. According to the fiscal theory of price level, the general price level is determined by the demand and supply of government debt instead of money supply. Quantitative easing itself has little inflationary effect because government debt and bank reserves are almost perfect substitutes for banks. Furthermore, it is possible to have a stable economy with a low interest rate without a Taylor rule-type intervention policy. Given that the majority of money in today's economy is used for financial transactions instead of buying goods and services, an alternative theory of price level based on the supply and demand of government debt offers a valuable new perspective. However, it is important to recognize the negative effects of low interest rates on institutions and populations relying on stable cash flows of fixed-income assets. Also, the valuation of the aggregate government debt portfolio is still a challenge for the asset pricing theory. The subjectivity of government debt discount rate implies that it could increase abruptly when investors become concerned about the government's ability to pay off its debt, in which case the resulting runaway from government debt in exchange for goods and services will jeopardize price stability. The fiscal theory of price level builds on the idea that price level is anchored by fiscal policy; a natural conclusion that should follow is that price stability must be built on fiscal discipline. The author thanks an anonymous referee and Wenfeng Wu (Editor) for valuable comments and suggestions.