Question

There is an inverse relationship between interest rate and money demand also there is an inverse relationship between interest rate and bond prices too. Do these relationships hold when interest rates are negative?

Thank you for your time.

Answer 1

Negative interest rate means, if $100 is borrowed, then less than $100 is returned back to the bank or financial institutions. So, negative interest rate, means there is a further decrease in interest rate and it will increase the demand. Hence, the relationship between interest rate and money demand holds. Further, when interest rate is negative, then bond prices will also increase. Though, negative interest rate happens when demand is very low and government and central bank is worried to increase the consumption. But, it can create a liquidity trap as well. So, if liquidity trap happens, then relationship will not hold correctly. It means that in a scenario of liquidity trap, demand of money will not increase. So, relationship will not hold in a scenario of liquidity trap.