Household behavior below the zero bound

One of the most salient macroeconomic developments in recent decades is the dramatic drop in interest rates. While nominal interest rates have historically been well within positive territory and conventional wisdom held that they could not fall below zero – the “zero lower bound” – central banks in Europe and Japan have recently resorted to negative policy rates to stimulate the economy.

In Denmark, where policy rates dropped below zero before anywhere else, banks have chosen to pass on the cost to households in the form of negative interest rates on deposits. In other countries, banks have largely refrained from doing so, but negative deposit rates are bound to become much more common if policy rates remain negative.

In this project, we ask: how do negative interest rates affect household consumption and investment? While the interplay between interest rates and household choices is a classical theme in economics, behavioral theory highlights several reasons why interest rate changes within negative territory (e.g. 0% to -0.5%) may induce very different responses than analogous changes within positive territory (e.g. +0.5% to 0%).

Most importantly, loss aversion suggests a higher sensitivity to negative rates (losses) than to positive rates (gains). This is reinforced by nominal illusion where gains and losses are perceived in nominal rather than real terms. By implication, past evidence on the transmission of monetary policy in positive territory may be less relevant in today’s negative territory.

Our empirical design uses data from a major Danish bank to accurately measure consumption, investment and deposit balances for around 1 million individuals and exploits sharp variation in exposure to negative rates created by the bank’s time-varying interest rate schedules.