[kybernetikos]

I'm obviously no expert, but I don't think it'd make sense for the real interest rate being higher under deflation to factor into anyones decisions about whether to make loans available, so the supply of loans would be lower.

Keeping the money in a hole in the ground gets you that return without taking on any risk, so when you're considering whether to invest your money in a potentially risky venture, you aren't going to care about the appreciation of money over the term of the loan.

My perspective is that if you want a return you consider the expected excess return over the risk-free return, and think about how much you're paying for that. Deflation increases the risk-free return you're comparing all investment opportunities with, so the number of opportunities with excess returns will diminish as that rate increases.

[jrek]

The availability of credit is a separate question from the interest rate, and may indeed fall.

Rising real interest rates directly impact borrowers and their ability to borrow, as their debt burden increases without any changes to interest rates. Borrowers are therefore both less likely and less able to borrow. Lenders may simultaneously decide not to lend. Japan is a good case study and has suffered from both phenomena. But interest rates in Japan are very low and fell substantially as soon as the economy got stuck in a deflation rut:

The charts below are illustrative if you set them both from 1979 to now:

https://tradingeconomics.com/japan/bank-lending-rate

https://tradingeconomics.com/japan/inflation-cpi

[kybernetikos]

Thanks, this is very interesting, and certainly gives me something to think about. Is the causation the right way round though (i.e. that the deflation has caused low interest rates)?

Could it be rather that because of the deflationary situation, the government tries to stimulate the economy with cheap money, and without that action, the natural rates of interest would be set by supply and demand and would be much higher?

[jrek]

I think you’re right on the supply side of the equation, that the profit motive applies upward pressure. But the constraint is on the demand side - if I increase or even maintain my interest rate, the number of borrowers that are able to service the loan drops and the amount of bad debt increases. That’s in addition to the general disincentive to bring forward spending caused by deflation, which has already reduced the pool of borrowers. If I lower my interest rate I’m making less money but still taking on the same risk (if I calibrated my reduction in the rate to that effect). I might then mitigate the risk by tightening my lending requirements. Or I can choose to just stop lending. The result is a simultaneous drop in interest rates and in available credit. The central bank can try to boost lending by dropping its interest rates. When rates get near or below zero things get weird.