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PBoC Working Paper: Digital Currency Strengthen the Effectiveness of Negative Rate Policies

Sun Guofeng, director general of the financial research institute at People’s Bank of China (PBoC), proposes to use the negative interest rate policy as a conventional monetary tool due to the natural low interest rates. He also emphasized the digital currency issued by PBoC could strengthen the effectiveness of negative interest rate policies. Therefore the central bank should accelerate the development of its own digital currency.   3f8e093a-ac87-11e6-a45e-e639c32a4ac5_1280x720

According to the latest working paper posted on PBoC’s website, a Dynamic Stochastic General Equilibrium (DSGE) model with the characteristics of a modern banking system has been established based on the Loan Creates Deposit (LCD) mechanism. On this basis, through model simulation data, Sun found that the deposit rate cuts may have a bad effect on the effectiveness of the negative interest rate policy and that’s why the Bank of Japan and the European Central Bank only got limited effects from the negative interest rate policy.

If the interest rate pass-through to deposit markets is complete, the deposit rate can penetrate the zero-rate range effectively. The powerful negative interest rate policy could be used to stabilize credit supply, as well as to combat deflation and low growth.

As we all know, the financial crisis is not a once-in-a-lifetime traumatic event. The negative interest rates policy which breaks through the zero-rate limit would become an important countermeasure when a deflationary recession comes in the future.

If the negative interest rates policy works, zero rate is no longer the baseline, thus, the central bank doesn’t have to raise the inflation to prevent interest rates touch the zero-baseline. On the contrary, it provide a chance for the central bank to lower the inflation target. In conclusion:

In a bank system which allows the interest rate to break through the zero-rate limit, the central bank could adopt deeply negative interest rate policy to combat deflationary recession;

Due to a the natural low interest rates, the monetary authorities could use the negative interest rate policy as a conventional monetary tool;

Digital currencies issued by central banks would strengthen the effectiveness of the negative interest rate policy, so the development of digital currencies should be put on the agenda.

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