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The reasons usually given for not targeting an

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Unformatted text preview: inflation? The reasons usually given for not targeting an inflation rate closer to zero focus on three issues: (i) problems caused by the constraint that interest rates cannot fall below zero; (ii) difficulties in measuring inflation accurately; and (iii) downward wage rigidities that could affect labour market adjustment. Nominal interest rates cannot fall below zero (the zero lower bound on interest rates) The main argument against a zero inflation target has to do with the inability of interest rates to fall below zero, known as the zero lower bound on interest rates (ZLB). When interest rates are at or close to zero, the ability of the central bank to use its traditional tool, the policy interest rate, to stimulate the economy is limited since actual (nominal) interest rates charged by banks cannot be negative. However, real (inflation-adjusted) interest rates can still be negative, if the inflation rate is higher than the actual interest rate. © Bank of Canada 2012 B A C K G R O What is the significance of having negative interest rates at times of serious economic weakness? When real interest rates are negative, there is an increased incentive for people to spend and borrow rather than save. Here’s why: if you deposit $100 in a savings account, it may earn you 2 per cent interest over one year; but if inflation is running at 4 per cent, your cash will be buying you less at the end of the year than it does now. The real rate of interest on your investment is a negative 2 per cent. So, in this case, you may choose to spend more now rather than save and have to fork out more money to buy later. Similarly, if you are a business owner looking to finance your purchases of machinery, and the real cost of borrowing today is negative, you may find it less costly to purchase the equipment now and pay later, than purchase when you have the money to pay...
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