Question

The United States has returned to a zero-interest rate policy in March 2020. Discuss the pros and cons of this policy. Should Australia opt for a zero-interest rate policy? Explain the answer

Answer 1

SOLUTION

ZERO INTEREST RATE POLICY

PROS Of ZERO INTEREST RATE

Although Zero interest rate policy ( ZIRP ) can be detrimental, policy makers in advanced economies continue to use the approach as a post-recession remedy. The primary benefit of low interests rate is their ability to stimulate economic activity. Despite low returns, near- zero interest rates lower the cost of borrowing, which can help spur spending on business capital, investment and household expenditures. Business increased capital spending can then create jobs and consumption opportunities. Likewise low interest rates improve bank balance sheets and the capacity to lend. Banks with little capital to lend were hit particularly hard by the financial crisis.Low interest rates can also raise asset prices. Higher asset prices combined with quandititive easing can increase the monetary base, resultig in an increase in household discretionary income.

CONS OF ZERO INTEREST RATE

Despite the U.S's progress, economies cite Japan and EU nations as the examples of the failure of ZIRP. Low interest rates have been attributed to the development of liquidity. Traps, which happens when saving rates becomes high and render monetary policy ineffective. Implementation of zero interest rates has mostly taken place after the recession when deflation, unemployment and slow growth prevail. Diminished investor confidence or mounting concern over deflation can also lead to liquidity traps. Additionally, despite zero interest rates and monetary expansion, borrowing can stagnate when corporations pay down debt from earnings rather than choosing to reinvest in the company. ZIPR can also lead to financial turmoil in the markets during periods of economic stability. When interest rates are low, investors seek higher yield instruments that are generally associated with risker assets.

AUSTRALIA WHEN OPTING ZERO INTEREST RATE

In Australia, one of the shorter-term domestic factors is weak consumption growth which has largely been driven by very weak wages growth. When growth in the economy is weak, this typically means that inflationary pressures are low and therefore interest rates need to be lowered, which would benefit the economy.