Negative interest

It was at Princeton that I first met Hans Tson Söderström, in 1975. His host there was Professor William Branson, an MIT-trained macroeconomist, engineer, and much-admired teacher doing brilliant work in open-economy macroeconomics with emphasis on stock-flow
dynamics. Branson had visited the Institute for International Economic Studies at the University of Stockholm, and was about to become my thesis advisor at Princeton.

At that time, inflation had become an important issue in the United States following OPEC’s oil price hike 1973-74. I was familiar with double-digit inflation from home. Iceland has had the OECD region’s second highest average inflation rate since 1960, after Turkey.

In my dissertation (Gylfason, 1976) I asked: Is inflation neutral? Or does it have real effects in the short and medium run? Long-run effects of inflation or other economic forces on growth at that time were considered out of the question (apart from Nelson and Phelps´s (1966) demonstration that education could have long-run effects on growth), and did not even become a serious theoretical possibility until the endogenous growth revolution ten years later.

I started – guess what! – from a simple IS-LM model where the IS equilibrium relationship via consumption and investment depended on real interest and the LM equilibrium relationship via the demand for money depended on nominal interest. This simple asymmetry, inspired by Mundell (1963), meant that increased inflation reduced real interest and hence stimulated output and employment through aggregate demand as long as aggregate supply responded either to a change in prices or in inflation. At this time the reaction against Keynes’s General Theory at Chicago and other places was gaining momentum. To accommodate monetarist sentiments, my take on the supply side was to argue that labor supply, determined jointly with consumption and saving in an intertemporal setting, also depended one way or another on real interest, admittedly a thin reed. In this asymmetric IS-LM setup, higher inflation led to lower real interest, thereby stimulating consumption, output, and employment in the short run and, by discouraging saving, retarding economic growth in the medium term in line with Tobin (1965). This was before it was generally noticed that the duration of the medium term can be derived from the parameters of the Solow growth model, an elegant result now routinely presented even in undergraduate courses on growth, and turns out to be quite long. A medium term spanning decades clearly reduced the policy relevance of the central tenet of the Solow model that the long-run rate of growth of per capita output could be traced solely to technological progress and hence was exogenous – that is, immune to macroeconomic policy or other economic forces.

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