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In expansionary monetary policy, it's written:

The Fed purchases more government bonds to drive down interest rates and increase the money supply.

Now, low interest rate can infer two things:

  1. People find it easier to take loans and invest. So, investment goes up.

  2. But, at the same time, low interest rate may mean that lenders may not be very keen on giving out loans. For example, people would find no use in keeping cash into bank accounts which provide low interest rates. This may drive down lending, and hence investment.

Is point (2) correct? If so, why is low n.i.r. considered good for economic growth?

Thanks

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  • $\begingroup$ In theory when interest rates are low, people should be keen to borrow - but Richard Koo has described how this did not happen in japan after their crash in the early 90s: youtube.com/watch?v=HaNxAzLKegU $\endgroup$
    – Mick
    Apr 12, 2022 at 7:25

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But, at the same time, low interest rate may mean that lenders may not be very keen on giving out loans. For example, people would find no use in keeping cash into bank accounts which provide low interest rates. This may drive down lending, and hence investment.

This is not entirely true. Bank profitability and willingness to lend depend on intermediation margin. Difference between the deposit or Fed funds interest rate and interest on loans they make.

For example a bank would be much happier to lend at 3% interest rate when federal funds rate or deposit rate is 0% than it would be happy to lend when interest rate is 20% but federal funds rate or deposit rate is 19.5% as they earn more profit at the lower rate with higher intermediation margin.

What low interest does is to discourage supply of saving, although even here the decision depends more on real interest rate than nominal one. Nonetheless, banks could always just get their funds from Fed, so unless Fed decides not to provide ample reserves they could in principle go on lending as much as they want.

If so, why is low n.i.r. considered good for economic growth?

It can actually be considered bad for the growth, but it is because of their effect on market concentration and firm productivity not because of any limits on loans. For example, Liu et al 2022 show that:

a decline in the long-term interest rate can trigger a stronger investment response by market leaders relative to market followers, thereby leading to more concentrated markets, higher profits, and lower aggregate productivity growth. This strategic effect of lower interest rates on market concentration implies that aggregate productivity growth declines as the interest rate approaches zero.

Moreover, Bikker & Vervliet (2017) argue low interest rates promote excessive risk taking which is clearly bad for macroeconomic stability.

Low interest rates can stimulate economic activity in short run, but long run economic growth depends on how fast productivity of different factors is growing.

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  • $\begingroup$ But in real terms, if inflation is higher than their nominal return which is the interest rate does it mean the banks real return is negative? And does that mean banks have had negative real return on their lending products in the past 15 years? $\endgroup$ Jun 22, 2023 at 0:37
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    $\begingroup$ But last 15 years inflation wasn't consistently higher than nominal interest rate banks charged (perhaps there were some small periods of time), if inflation would be higher then real return would be negative but also remember bank does not lend its own capital so it still makes sense to lend as long as nominal return is sufficient to cover nominal interest CB charges on reserves (plus any other wage costs for people doing this but those tend to be very small relative to volume of lending) $\endgroup$
    – 1muflon1
    Jun 22, 2023 at 15:30

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