The Side Effects of Safe Asset Creation
An increase in the demand for safe assets puts downward pressure on the natural rate of interest, forcing a central bank to lower the nominal interest rate to avoid an increase in unemployment. A large enough increase in this demand for safety can cause the nominal rate to hit the zero lower bound (ZLB). This prevents the central bank from providing enough accommodation, resulting in a rise in unemployment.
This paper studies the costs and benefits of increasing government debt when an increase in demand for safe assets pushes the natural interest rate below zero.
An increase in the supply of safe government debt can accommodate the demand for safe assets. This reduces the downward pressure on the natural rate of interest and allows monetary policy to attain its goals of price stability and full employment. However, such a policy may have unintended side effects, resulting in permanently lower investment and lower welfare in the long run. Despite this downside, increasing debt until the ZLB is no longer binding raises welfare when the central bank is unable or unwilling to raise the inflation target. In contrast, a higher inflation target allows for negative real interest rates and achieves full employment without reducing investment.