Consequences of abolishing cash as a mean of overcoming the zero lower bound
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Kirkegaard Olsen, Dennis1, Forfatter
Henrik, Jensen2, Vejleder
1Det Samfundsvidenskabelige Fakultet, Københavns Universitet, København, Danmark, diskurs:7001              
2Økonomisk Institut, Det Samfundsvidenskabelige Fakultet, Københavns Universitet, København, Danmark, diskurs:7014              
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Ukontrollerede emneord: Monetary policy, Liquidity traps, abolition of cash, defaltionary crisis
 Abstract: The current economic crisis is the most severe since the Great Depression in the 1930s. The consequences of the economic downturn on the individual agents are obvious as unemployment has risen, stock markets and retirement savings have plumbed, the house market has staggered and financial services have become increasingly expensive. Worries about a deep and prolonged financial and macroeconomic crisis are no longer just a subject in economists’ circles; it has become a household concern as well.
In a first attempt to stimulate the economy, central banks around the world lowered their official policy interest rate markedly to basically zero. Zero is a natural lower bound to the interest rates as cash yields zero interest. Were the nominal interest rate below zero, there would be an arbitrage opportunity, as agents could loan money at negative interest rates and place it in zero interest yielding cash, thereby making a riskless profit. When monetary policy is ineffective to affect the real economy, the economy is said to be in a liquidity trap.
The zero interest rates have not been sufficient to create an economic recovery. Subsequently, central banks have sought uncharted waters for alternative policy tools. Their favorite unconventional policy instrument has been quantitative easing. The widespread use of this instrument leaves it debatable whether it can genuinely be described as unconventional policy.
Nonetheless, quantitative easing also poses limits and risks concerning the long run effect. Especially central bank purchases of long term government bonds have provoked discussions among economists.
The combination of the devastating effects of the current economic situation and the lack of adequate monetary policy tools, naturally leads to an exploration of alternative instruments. This master thesis analyzes one alternative instrument thoroughly. The main underlying proposition analyzed in this thesis is to expand the central banks’ range for conducting standard conventional monetary policy through interest rate setting. This is done by providing them the possibility to set their nominal interest rate in the negative spectra. To avoid the arbitrage possibility arising from cash, money has to be imposed with negative interest rates as well or taxed or abolished.
To examine the effects and consequences of various solutions I formulate a New-Keynesian model which is the standard model for analyzing monetary policy. The model is founded on microeconomic optimizing behavior by forward looking agents. It is demonstrated how the zero lower bound equilibrium is a theoretical possibility containing deflation in the long run. In standard macroeconomics, however, this scenario is often ignored and ruled out by arguments of rational expectations.
Quantitative easing expands the money base and thereby stimulates the economy through increased inflation expectations. This explanation is, of course, too simple and does not show the full picture. The present crisis is characterized by fading internal confidence in the financial markets leading to liquidity shortage. Apart from the direct stimulating effect through the expanded money base, an important argument for a quantitative easing is to offset the lack of liquidity. This paper, however, focuses on alternative solutions for the direct stimulating channel.
In contrast to quantitative easing, a more straight forward solution to the zero lower bound is to let the monetary authorities continue to conduct monetary policy in their regular form by expanding the range for interest rate setting. This is done by introducing interest rates on money, which consequently eliminates the previous arbitrage opportunity. The paper demonstrates in the New-Keynesian framework, how this proposition removes the zero lower bound steady state and simultaneously secures a single global stationary equilibrium.
One hurdle regarding interest rates on money is the difficulties in collecting negative interest rates on cash. Cash is an anonymous bearer asset, which means the identity of the owner is unknown to the issuer. Consequently, there is no incentive for the bearer to step forward and pay the negative interest. Various solutions for taxing cash have been proposed and several of these are discussed in the paper. However, all propositions have in common that they are costly or administratively difficult.
The paper analyzes a different approach where cash is completely abolished in the economy. By doing this, it is possible for the central bank at trivial cost to impose negative interest on money, which will only consist of electronic and registered funds. The central bank is thereby no longer constraint when setting their policy interest rate, which can be set at any level, positive as well as negative.
The paper also discusses the possibilities and the broader consequences of abandoning cash. First of all, it is found that technology is not a constraint for a completely abolition of cash. Numerous alternative mediums for exchange already exist, which can be exploited further.
Regarding monetary policy, it has been debated whether a central bank will be able to control interest rate levels in the absence of cash. An important conclusion is that an abandoning of cash does not alter the ability to conduct conventional monetary policy for a central bank. The central bank will still be able to control the interest rates throughout the economy because they act as the last settlement for the financial sector. Interest rates will therefore always be anchored by the deposit and borrowing rates at the central bank.
A number of recently published surveys by European central banks show that the social cost associated with transactions involving cash is substantially higher than with credit cards. The cost per transaction with credit cards further diminishes as the number of transaction raises and the technological opportunities are exploited. Abandoning cash in favor of increased use of credit card, smart card, etc. could therefore yield a financial benefit.
The paper also explores potential negative effects from the cashless society. Firstly, the government loses the revenue obtained through seigniorage. This can be replaced, however, by imposing negative interest rates for reserves held at the central bank. Secondly, cash is the favorite medium for small transactions. The paper suggests keeping notes and coins with small notation for the everyday transactions. This will not create the previous arbitrage, as hoarding large amounts in small notation coins and notes will simply be too inconvenient and expensive to store.
This thesis concludes that abandoning cash and imposing negative nominal interest rates on money and government liabilities is a feasible instrument to create an economic recovery during a crisis. The central bank is thereby able to conduct monetary policy in the same way as always. In addition, this solution not only helps a current recovery but also prevents future liquidity traps.
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Bogmærk denne post:
 Type: Speciale
Alternativ titel: Konsekvenserne ved at afskaffe kontanter for at undgå arbitrage ved nulrentepolitik
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Sprog: English - eng
 Datoer: 2011-12-06
 Sider: -
 Publiceringsinfo: København : Københavns Universitet
 Indholdsfortegnelse: Contents
1 Introduction . - 3 -
1.1 Problem statement and objective of the paper . - 5 -
1.2 Outline . - 6 -
1.3 A few definitions . - 6 -
2 Current economic situation . - 7 -
2.1 General macroeconomic considerations - 7 -
2.2 Deflation - 8 -
2.3 Stimulating the economy - 9 -
2.4 The Taylor rule - 10 -
2.5 The zero lower bound . - 11 -
2.6 Liquidity trap . - 12 -
2.7 Textbook solutions - 13 -
3 Review of existing literature - 15 -
3.1 Krugman - 16 -
3.2 Ugai . - 18 -
3.3 Gesell . - 18 -
3.4 Wörgl . - 20 -
3.5 Buiter and Panigirtzoglou - 21 -
3.6 Goodfriend - 24 -
3.7 Fukao . - 26 -
3.8 Buiter . - 29 -
3.9 Woodford - 31 -
4 Theoretical model - 33 -
4.1 Regular model . - 33 -
4.2 Model with interest on money . - 52 -
5 Abandoning cash . - 55 -
5.1 Complications of a carry tax - 55 -
5.2 A cashless society - 56 -
6 Reflections . - 58 -
6.1 Loss of an anonymous asset . - 58 -
6.2 Government - 59 -
6.3 The role of the central bank - 60 -
6.4 Is it technologically feasible? - 61 -
6.5 The public - 63 -
6.6 Social cost - 64 -
6.7 Summary . - 65 -
7 Conclusion. - 68 -
8 References . - 71 -
9 Appendix: . - 75 -
9.1 The envelope theorem - 75 -
9.2 Calculation leading to equation (4.26) - 75 -
9.3 Approximation of equation (4.20) - 76 -
9.4 Approximating equation (4.14) . - 77 -
9.5 Proof of unique equilibrium - 78 -
9.6 Indeterminacy at the zero lower bound - 79 -
 Note: -
 Type: Speciale
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