Economics
Effective Lower Bound
The Effective Lower Bound refers to the lowest level to which central banks can set short-term interest rates to stimulate the economy. When interest rates approach this bound, it becomes challenging for central banks to further lower rates to boost economic activity. This can lead to limitations in traditional monetary policy tools and may necessitate unconventional measures to support the economy.
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9 Key excerpts on "Effective Lower Bound"
No longer available |Learn more- Janice Eberly, James H. Stock, Janice Eberly, James H. Stock(Authors)
- 2019(Publication Date)
- Brookings Institution Press(Publisher)
521 KRISTIN FORBES Massachusetts Institute of Technology–Sloan School of Management Monetary Policy at the Effective Lower Bound: Less Potent? More International? More Sticky? ABSTRACT This paper discusses whether monetary policy at the Effective Lower Bound (ELB) is less effective, generates greater international spillovers, or is “stickier” than conventional monetary policy. It argues that monetary policy at the ELB can be potent and that there has thus far been no convincing evidence that it has greater international spillovers through capital flows and exchange rates than comparable adjustments in interest rates. It may be more challenging to raise rates off the ELB than to raise rates from higher levels— possibly due to counterbalancing effects through the exchange rate—although there are only anecdotes to support this stickiness rather than any formal, empirical evidence. D uring the 2008 global financial crisis, many advanced economies lowered their policy interest rates to their Effective Lower Bounds (ELBs). In some countries, these interest rates are still there. In the future, there is a good chance that many central banks will operate at the ELB more often, especially given the fall in the global neutral interest rate ( r *) and the high probability that the next slowdown will come before inter est rates are raised to levels from which they could be lowered enough to provide a substantial stimulus. Understanding how monetary policy at the ELB is different from “conventional” monetary policy is therefore critical for thinking about monetary policy in the future. This paper explores three ways in which monetary policy at the ELB may differ from more “conventional” monetary policy—defined as primarily Conflict of Interest Disclosure: The author did not receive any financial support from any firm or person for this paper or from any firm or person with a financial or political interest in this paper.
No longer available |Learn more- Janice Eberly, James H. Stock(Authors)
- 2017(Publication Date)
- Brookings Institution Press(Publisher)
1 (2013): 139–211; Paul R. Krugman, “It’s Baaack: Japan’s Slump and the Return of the Liquidity Trap,” Brookings Papers on Economic Activity, no. 2 (1998): 137–87. COMMENTS and DISCUSSION 391 of the Effective Lower Bound over many years as a way of buttressing the economy. Pushing down long-term rates is what matters. Finally, Kocherlakota thought it was useful to back up from the technical language of “zero lower bound” and “Effective Lower Bound” and to think about the economics of it all. Economic theory suggests that the zero lower bound is a problem created by the existence of government-provided cur-rency as a store of value: The government provides a store of value with a nominal interest rate of zero to its citizens. If that were to be eliminated, the problem would be eliminated, he contended. As economists, this is an argu-ment to get rid of currency, or at least to limit high-denomination notes, as had been suggested by Kenneth Rogoff and Miles Kimball. 3 Alan Blinder completely agreed with Kocherlakota’s assessment. William English believed it was important, in practice, to think about other monetary policy tools, such as asset purchases. The authors, in effect, focus only on forward guidance. A recent paper by David Reifschneider suggested that at the zero lower bound, asset purchases might be a good substitute for lower short-term rates. 4 There is more work to be done on the topic, but it is a direction he wanted explored more. Benjamin Friedman had three observations. First, he believed an interest-ing element of the paper to which the authors did not pay much attention— but one that might be worth developing—is the existence of the variable on the right-hand side of their equation 1 representing the change in the output gap. The inclusion of the term in the monetary response function is helpful because it prevents the central bank from tightening too quickly in a recov-ery period.
eBook - ePub- John H. Cochrane, John B. Taylor, John H. Cochrane, John B. Taylor(Authors)
- 2020(Publication Date)
- Hoover Institution Press(Publisher)
– 67.- Mendes, Rhys R. 2011. “Uncertainty and the Zero Lower Bound: A Theoretical Analysis.” Bank of Canada.
- Mertens, Thomas M., and John C. Williams. 2018. “What to Expect from the Lower Bound on Interest Rates: Evidence from Derivatives Prices.” Federal Reserve Bank of San Francisco, Working Paper 2018-03, August.
- ________ . 2019. “Monetary Policy Frameworks and the Effective Lower Bound on Interest Rates.” American Economic Review, Papers and Proceedings 109 (May): 427– 32.
- Nakata, Taisuke, and Sebastian Schmidt. 2019. “Gradualism and Liquidity Traps.” Review of Economic Dynamics 31 (January): 182– 99.
- Reifschneider, David L., and John C. Williams. 2000. “Three Lessons for Monetary Policy in a Low-Inflation Era.” Journal of Money, Credit and Banking 32, no. 4 (November): 936– 66.
- Svensson, Lars E. O. 1999. “Price Level Targeting vs. Inflation Targeting: A Free Lunch?” Journal of Money, Credit and Banking 31, no. 3 (August): 277– 95.
- ________ . 2019. “Monetary Policy Strategies for the Federal Reserve.” Mimeo, Stockholm School of Economics
- Taylor, John B. 1985. “What Would Nominal GDP Targeting Do to the Business Cycle?” In Carnegie-Rochester Conference Series on Public Policy 22: 61– 84.
- ________ . 1993. “Discretion versus Policy Rules in Practice.” Carnegie-Rochester Conference Series on Public Policy 39 (December): 195– 214
- Vestin, David. 2006. “Price-Level versus Inflation Targeting.” Journal of Monetary Economics 53, no. 7 (October): 1361– 76.
- Woodford, Michael. 2003. Interest and Prices: Foundations of a Theory of Monetary Policy. Princeton. NJ: Princeton University Press.
APPENDIX A: UPPER BOUND
The various conditions determine whether a constraint never binds, ; occasionally binds, ; or always binds,
eBook - ePub- Livio Stracca(Author)
- 2018(Publication Date)
- Routledge(Publisher)
10 Moreover, central banks are ultimately responsible for the management of aggregate demand in the economy, and cannot think of always being ‘bailed out’ at the ZLB by the fiscal authority. Therefore, central banks have to find their own way out of the ZLB.Five ways out of the ZLB
By now it should be clear that the zero bound is a significant problem for monetary policy. What a monetary policy would want to do is to run a policy that overcomes the zero bound, i.e. set aggregate demand at a level that would result from a negative interest rate, even if that cannot be obtained. The common idea is to set policy so that its effects are the same as those which would prevail if the nominal short-term interest rate would be allowed to be negative. In fact, the effectiveness of these measures is often gauged by some kind of ‘shadow’ interest rate, i.e. the interest rate below zero that truly corresponds to the current stance of policy and that the zero-bounded interest rate cannot properly measure. Figure 4.1 reports one of such measures for the United States, and at the same time illustrates just how widespread the ZLB problem is in advanced countries.FIGURE 4.1 Short-term interest rates in the world’s major industrialised economies. The Wu-Xia ‘shadow’ federal funds rate is an indicator of the interest rate that takes into account the effect of non-standard measures such as QE.In the rest of this chapter, we are going to see four of five possible ways to circumvent the zero bound. It is important to note from the outset that none of them is still a fool-proof way to overcome the ZLB. Economists are divided on whether any of these method are really effective, and it is fair to say that the profession is still rather divided on whether there is any practical solution at all for the ZLB problem.
- Takatoshi Ito, Andrew K. Rose, Takatoshi Ito, Andrew K. Rose(Authors)
- 2007(Publication Date)
- University of Chicago Press(Publisher)
There are two broad sets of lessons worth highlighting from this sum-mary. The first concerns the appropriate level of the steady-state neutral nominal interest rate—the sum of the economy’s neutral real interest rate and policymakers’ choice of target inflation rate. From table 2.1 we see that, even for a very low neutral nominal interest rate of i ∗ 3 percent, in most scenarios the ZLB has relatively little e ff ect on the thinking of an ac-tivist policymaker until the bubble has become quite large. 25 Moreover, as figures 2.3, 2.6, and 2.8 confirm, even those “ZLB e ff ects” in table 2.1 that Monetary Policy, Asset-price Bubbles, and the Zero Lower Bound 71 Table 2.1 Impact of the ZLB on an activist’s recommendations Scenario Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Policy can’t affect bubble p t = 0.2, baseline model = = = – – – p t = 0.4, baseline model = = = = = – p t = 0.4, β = 0.5 = = – – – – p t = 0.4, λ = 0.6 = = = = = = p t = 0.4, λ = 1.0 = = = = – – Policy affects bubble growth = = = = – – Policy affects probability of bursting p * = 0.4, δ = 0.2 = = + + – – Note: Tighter (+), looser (–), or little different (=) than otherwise, i * = 3.0. 25. The two exceptions are: when the bubble’s probability of bursting may be influenced by policy; and when the bubble is exogenous but the economy is relatively unresponsive to poli-cymakers’ actions. In these two cases the “ZLB e ff ect” exceeds 25 basis points when the bubble is still only of a moderate size. are not negligible dissipate rapidly as the neutral nominal interest rate is raised above 3 percent. These observations suggest that fears of encountering the ZLB should not be overstated, unless the neutral nominal interest rate in the economy is very low. They thus have an obvious implication for policymakers anx-ious not to have to worry about factoring the ZLB into their thinking when trying to cope with an asset-price bubble.
eBook - PDFZero Lower Bound and Monetary Policy in the Euro Area
Optimal Monetary Policy in a Low Inflation Environment
- Lars Protze(Author)
- 2008(Publication Date)
- Diplomica Verlag(Publisher)
Since the nominal rate is bounded at zero the central bank sets the nominal rate equal to zero whenever the Taylor rule suggests a negative rate of interest. For low inflation targets the probability that the zero bound binds is larger than for higher target values. Announcing this somewhat higher inflation target lowered the probability that the bound binds. However, once the bound does bind this helps not to escape because the necessary history dependence that has the power to influence expectations in the right manner is not induced by an inflation target but by a price level target. So that in the following other ways out of a recession have to be considered. 4.2 Avoiding or escaping the negative consequences Here possible ways to escape the trap or to avoid it will be presented in the following paragraphs. 4.2.1 Exchange rate policy One possibility to escape is to use exchange rate interventions. Through a direct effect of foreign currency interventions on aggregate demand or through exchange rate interventions that raise the nominal interest rate and inflation. 66 4.2.1.1 The exchange rate mechanism Monetary policy should aim to depreciate its own currency to raise interest rates and inflation. One possibility is to conduct a one time devaluation and then follow an exchange rate peg until the bound stops being a constraint. 56 Another possibility is to use the exchange rate as a policy instrument when the zero bound binds and insert it in a Taylor rule as the following. 57 ( ) t t t t t t e x E p s s + − − ∆ − = − − ∗ − 1 2 1 0 1 µ π µ µ With 0 , 2 1 > µ µ and t s as the log of the nominal exchange rate. This rule determines the rate of depreciation of the own currency as a reaction function depending on the output gap and the deviation of the rate of inflation from its target. When deflation occurs monetary policy aims at depreciating the currency. The depreciation is even stronger when output is below potential.
eBook - ePub- Benjamin M. Friedman, Michael Woodford(Authors)
- 2010(Publication Date)
- North Holland(Publisher)
The contrast arises from the fact that, both at the decision level and for purposes of policy implementation, what most central banks do is set short-term interest rates. In most cases they do so not out of any inherent preference for one interest rate level versus another, but as a means to influence dimensions of macroeconomic activity like prices and inflation, output and employment, or sometimes designated monetary aggregates. But inflation and output are not variables over which the central bank has direct control, nor is the quantity of deposit money, at least in situations considered here. Instead, a central bank normally exerts whatever influence it has over any or all of these macroeconomic magnitudes via its setting of a short-term interest rate.At a practical level, the fact that setting interest rates is the central bank’s way of implementing monetary policy is clear enough, especially now that most central banks leave abandoned or at least downgraded the money growth targets that they used to set. (This happened mostly during the 1980s and early 1990s, although some exceptions still remain.) The centerpiece of how economists and policymakers think and talk about monetary policy is now the relationship directly between the interest rate that the central bank fixes and the economic objectives, such as for inflation and output, that policymakers are seeking to achieve. (Further, even when central banks had money growth targets, what they mostly did in an attempt to achieve them was set a short-term interest rate anyway.)This key role of the central bank’s policy interest rate is likewise reflected in what economists write and teach about monetary policy. In place of the once ubiquitous Hicks-Keynes “IS-LM” model, based on the joint satisfaction of an aggregate equilibrium condition for the goods market (the “IS curve”) and a parallel equilibrium condition for the money market for either given money supply or a given supply of bank reserves supposedly fixed by the central bank (the “LM curve”), today the standard basic workhorse model used for macroeconomic and monetary policy analysis is the Clarida-Galí-Gertier “new Keynesian” model consisting of an IS curve, relating output to the interest rate as before but now including expectations of future output too, together with a Phillips-Calvo price-setting relation. The LM curve is gone, and the presumption is that the central bank simply sets the interest rate in the IS curve. The same change in thinking is also reflected in more fundamental and highly elaborated explorations of the subject. In contrast to Patinkin’s classic treatise (1956 , with an important revision in 1965) , Money, Interest, and Prices , Woodford’s 2003 treatise is simply Interest and Prices
eBook - PDFThe Reform of Macroeconomic Policy
From Stagflation to Low or Zero Inflation
- J. Perkins(Author)
- 2016(Publication Date)
- Palgrave Macmillan(Publisher)
the other macroeconomic objectives. In particular, low, zero or nega- tive inflation greatly reduces the scope for using monetary policy to stimulate activity. For nominal interest rates cannot in practice be neg- ative; so that when inflation is low or zero (and especially if it is neg- ative) real interest rates may be high even when nominal interest rates are low but positive. If the available indexes of inflation exaggerate the actual rate of inflation, the real burden of repaying debts, and the interest on them, may be increasing even when inflation as usually measured is moderately positive. Attempts by central banks to ease monetary policy by buying bonds may in such circumstances be unsuccessful in stimulating activity. People may simply hold the additional money, and interest rates not be reduced, so that activity is not stimulated. This is known as an ‘infinitely elastic demand curve for money’. In the General Theory Keynes referred to an old city saying, ‘John Bull can stand many things, but he cannot stand 2 per cent’. This was clearly intended to imply that (presumably long-term) interest rates of 2 per cent or less would lead to a lapse of confidence in the bonds bearing such a low rate. (In a period when the general level of prices was thought to be on the average as likely to fall as to rise, one must assume that this was also a minimum real rate of interest of 2 per cent.) One may call to mind the disastrous attempt of Hugh Dalton, as Chancellor of the Exchequer in the late 1940s, to reduce the long-term bond rate to about 2 per cent. The result was a failure to sell govern- ment bonds at such a low rate. This implies that, in practice, a mone- tary authority will not be wise to attempt to reduce nominal interest rates to very low levels. The constraint on its actions is therefore much tougher than the fact that nominal interest rates cannot be negative.
eBook - PDFMonetary Policy in the Context of Financial Crisis
New Challenges and Lessons
- Fredj Jawadi, William A. Barnett(Authors)
- 2015(Publication Date)
- Emerald Group Publishing Limited(Publisher)
This will be neutral with respect to inflation if the equilibrium short-term real interest rate is 2%. 1 If inflation falls to say 0% and is expected from the time series evidence to stay there, the benchmark rule calls for an i * of 1%, or 3% below its normal level of 4%. This implies a real rate of 1%, which is less than its assumed equilibrium level of 2%, and hence would put upward pressure on inflation, driving it back toward the Fed’s announced target of + 2%. But if inflation falls to say − 2% (i.e., 2% de flation) and is expected to stay there, the benchmark rule calls for an impossibly negative i * of − 2%. Because of the Zero Lower Bound (ZLB) on nominal interest rates, the lowest i * can ordinarily go is 0%. This would imply a real rate of + 2%, which would not be stimulative at all, and so would permit inflation to drift even lower. With any deeper expected deflation, the ZLB would actually lead to an even higher real rate and further downward pressure on inflation, 1 The equilibrium real interest rate is that determined in the absence of a monetary disequilibrium by the supply and demand for saving, as in the “Loanable Funds Model” of Irving Fisher (1930/1974) . This is equivalent to Knut Wicksell’s “Natural Rate of Interest,” as discussed by Friedman (1968) . 406 J. Huston McCulloch which has led many economists to fear the possibility of an unstoppable deflationary spiral. This supposed ZLB threat has been used as a rationale for deliberately targeting a positive inflation rate in order to give the Fed some additional space to reduce nominal rates before hitting the ZLB, in spite of the Fed’s legislative mandate to stabilize prices. In 2012, the Fed in fact announced its intention to target 2% inflation, in part for this very reason. We will see that this fear is unwarranted. But first, let us consider how the Taylor Rule may be expected to operate when the ZLB is not binding.
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