An Unconventional Policy

Lemia Bickalo


March 22nd, 2019

Unlike Keynes in 1936, technology means that we are no longer restricted to the assumption that cash cannot bear interest. Lemia Bickalo explores unconventional monetary policy in the modern age.

Macro Crash Course

In an economy, central banks use open market operations and reserve requirements to control the money supply and interest rates. These tools form conventional monetary policy. However, recent years have seen monetary policy enter a new world with the implementation of nonconventional measures in response to the interest rate hitting a floor of zero, or the ‘zero-lower-bound’. The zero-lower-bound problem occurs because people will only accept positive interest rates on bonds. Nominal interest rates cannot be reduced below zero, as in this situation people will simply hoard cash rather than buying more bonds.

During the Global Financial Crisis, the major economies were in a liquidity trap. A liquidity trap is a situation in which, based on Keynesian economics, “after the rate of interest has fallen to a certain level, liquidity preference may become virtually absolute in the sense that almost everyone prefers [holding] cash [rather than] holding a debt which yields so low a rate of interest.”[1] In other words, we have reached the zero-lower-bound.

During a recession,there is a chronic shortfall of demand (spending) which requires lowering interest rates to increase aggregate demand and get the economy to the ideal level of output. However as mentioned above, lowering interest rates towards zero means people prefer to hold cash. If cash could, theoretically, be subject to a negative interest rate, the cost of holding cash would increase and people would prefer to spend. But more on that later.

Quantitative easing is an unconventional monetary policy in which a central bank purchases government bonds or other securities from the market in order to lower interest rates and increase the money supply.[2] QE involves the purchasing of securities beyond the traditional scope of open market operations, and is used when short-term interest rates approach zero, limiting the effectiveness of traditional monetary policy. Increasing the money supply by flooding financial institutions with capital lowers the cost of lending money. Increased lending means more investment, which grows the economy. However, the central bank cannot force banks to lend out money.

In fact, in the US, money supply did not undergo the large expansion that was expected with QE. Instead, there was a massive rise in excess reserves, while bank lending (which increases the money supply) did not increase. Banks were willing to hold excess reserves because the Federal Reserve began paying interest on these reserves which often exceeded the rate at which the banks could lend them out in the overnight market.[3]

Despite the number of major central banks that deployed quantitative easing, it has proven to be complex and ineffectual.[4]

Keynes for the modern age

So, asides from increasing money supply, how can central banks stimulate demand when the interest rate cannot go into negative territory?

The issue is the nature of cash. Keynes assumed that money has a zero rate of return because the definition of money he used included currency (which earns no interest) and account deposits (which at the time earned little or no interest). Bonds, the only alternative asset to money in Keynes’s framework, have an expected return equal to the interest rate. As the interest rates falls (holding everything else unchanged), the expected return on money increases relative to the expected return on bonds, causing an increase in the quantity of money demanded.[3]

The zero return on cash is the foundation of the zero-lower bound on monetary policy, because if bank deposit rates become too negative (as a result of lowering of interest rates by the central bank to stimulate spending), depositors can always switch to storing cash.

However, things are different in today’s technological age. We are no longer restricted to the principle that cash earns no return, as Keynes was in his time. In theory, digital cash referred to as central bank digital currency (CBDC) – can yield essentially the same rate of return as other risk-free assets (account deposits and reserves).

All money is equal, but some money is more equal than others

In theory, CBDCs could be yield-bearing or not. The later having the purpose of replicating cash in the digital form, while the former opens up new possibilities for monetary policy. Digital money would be able to carry adjustable interest rates, either positive or negative.

Negative interest rates propose a solution for overcoming the problems of the zero-lower bound, since reducing the zero-lower bound requires increasing the costs of holding cash to reduce its usefulness. For example, in the event of a financial crisis, the central bank would be able to reduce the digital cash interest rate below zero, unlike during the GFC when the zero-lower-bound prevented negative rates. This would make holding cash less appealing than holding other financial assets, thereby stimulating demand at the zero-lower-bound and beyond.[4]

In contrast to negative rates, an increase in the demand for holding CBDC will occur if a return can be paid on it. It’s possible to pay interest on a central bank digital currency, as it is possible today to pay interest on the reserves of the commercial banks. It would be expected that the interest rate paid by the central bank on reserves would be the same as the interest rate paid on CBDC, as each reflects the setting of monetary policy. To ensure that bank deposits don’t run the risk of depletion, the return on digital cash should be have an upper bound so that it doesn’t exceed the deposit rates offered by commercial banks.[5]

In summary, allowing for negative interest rates on digital cash would, in theory, lower demand for cash, stimulating demand for alternative financial assets and bolstering spending. This would increase aggregate demand and push the economy to produce its ideal output. Despite being incredibly unconventional, flawed, and requiring a transition to a cashless economy, it just might work.

[1] Keynes, J. M. (1936). The general theory of employment, interest, and money. Retrieved from

[2] Investopedia. (2019). Quantitative easing. Retrieved from

[3] Mishkin, F. S. (2016). The economics of money, banking and financial markets (11th ed.). Harlow, Essex: Pearson Education Limited

[4] Bordo, M. D & Levin, A. T. (2018, June). Central bank digital cash: principles and practical steps. Paper presented at the SUERF conference, Milan LM. Retrieved from

[5] Agur, I. (2018, June). Central bank digital currencies: an overview of pros and cons. Paper presented atthe SUERF conference, Milan LM. Retrieved from

Image: Max Pixel

The views expressed within this article are those of the author and do not represent the views of the ESSA Committee or the Society's sponsors. Use of any content from this article should clearly attribute the work to the author and not to ESSA or its sponsors.

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