[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.