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Collection of full-length papers and in-depth analysis of economic and management issues.

Two Sides of Low Interest Rate Policy And Recommendations

Two Sides of Low Interest Rate Policy And Recommendations

YU Jung-Suk

June 30, 2009

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Originally released on May 11, 2009

ABSTRACT

To stabilize financial markets and to get the real economy back on its feet again, the central banks of major countries are cutting interest rates in tandem with quantitative easing. The low interest rate policy, however, is a double-edged sword. In the past, whenever the real economy slumped due to financial crises, the central banks of major countries attempted to boost consumption and investment by slashing their benchmark interest rates. This policy, however, cuts both ways. It supports the economic recovery by helping to provide abundant liquidity but any excess liquidity can lead to a bubble in asset prices.

Three things can be said about the low interest rate policy. First, substantial cuts in the Bank of Korea's benchmark interest rate and expansion of liquidity since late 2008 have eased both the interest payment burden on mortgage loans and the cash crunch facing private companies. Second, the domestic benchmark interest rate is estimated to be very close to the equilibrium rate according to the Taylor Rule, leaving almost no room for additional rate cuts. Third, despite the rate cuts and the sharp increase in money supply, there is no clear sign of inflation thanks to the steep decline in the circulation velocity of money. Asset prices, however, are now under increasing upward pressure as the recent boost in liquidity is gravitating toward the financial market instead of the real economy.

The government may have to maintain the current monetary stance and freeze the interest rate for the time being. However, it will need to shift the direction of monetary policy toward tightening money supply if the circulation velocity of money increases and inflation pressure emerges as financial instability eases. Even in this case, the government should attempt first to absorb the liquidity through the issuance of currency stabilization bonds, while taking a prudent approach to interest rate hikes since it risks prematurely cooling off the economy.

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