jmherbenerPrice deflation is the consequence of having a fixed money stock with an increasing money demand. There is no more money in society and thus, the increasing production of goods (which is the fruit of capital accumulation during periods of economic growth) implies that their prices must be lower. In such circumstances, people receive their higher standards of living in the form of lower prices of goods and not larger money incomes. Their money incomes might even decline, but their real incomes are rising. So people do not have more money to lend. The money stock is fixed.
If interest rates were negative, borrowers would want to borrow enormous amounts. Lending, however, would be nil. Given the option between holding onto $100 for a year and having $100 a year later and lending $100 to receive $95 back in a year, no one will lend. This is the reason the interest rate cannot be negative.
The pure rate of interest is independent of the stock of money. It is determined by time preferences alone. A person’s degree of time preference is manifest in the premium in the purchasing power of money in the future he requires to part with money of a given purchasing power in the present. For example, if a person has a 2 percent rate of time preference, then he requires $102 a year from now to be willing to lend $100 today when the purchasing power of money is the same a year from now as it is today. If the PPM is 5 percent lower a year from now, then for him to be willing to lend $100 today he would require $107 a year from now. In either case, the pure rate of interest is 2 percent.