Zero lower bound

Abstract: We develop a quantitative monetary DSGE model with financial intermediaries that face endogenously determined balance sheet constraints. We then use the model to evaluate the effects of the central bank using unconventional monetary policy to combat a simulated financial crisis. We interpret unconventional monetary policy as expanding central bank credit intermediation to offset a disruption of private financial intermediation. The primary advantage the central bank has over private intermediaries is that it can elastically obtain funds by issuing riskless government debt. During the crisis, the balance sheet constraints on private intermediaries tighten, raising the net benefits from central bank intermediation. We find that the welfare benefits from this policy may be substantial if the relative efficiency costs of central bank intermediation are modest. Further, in a financial crisis there are benefits from credit policy even if the nominal interest has not reached the zero lower bound. In the event the zero lower bound constraint is binding, however, the net benefits from credit policy may be significantly enhanced.

Abstract: We argue that the government-spending multiplier can be much larger than one when the zero lower bound on the nominal interest rate binds. The larger the fraction of government spending that occurs while the nominal interest rate is zero, the larger the value of the multiplier. After providing intuition for these results, we investigate the size of the multiplier in a dynamic, stochastic, general equilibrium model. In this model the multiplier effect is substantially larger than one when the zero bound binds. Our model is consistent with the behavior of key macro aggregates during the recent financial crisis.

Abstract: THE CONSEQUENCES FOR THE PROPER conduct of monetary policy of the existence of a lower bound of zero for overnight nominal interest rates has recently become a topic of lively interest. In Japan the call rate (the overnight cash rate analogous to the federal funds rate in the United States) has been within 50 basis points of zero since October 1995, and it has been essentially equal to zero for most of the past four years (figure 1). Thus the Bank of Japan has had little room to further reduce short-term nominal interest rates in all that time. Meanwhile Japan's growth has remained anemic, and prices have continued to fall, suggesting a need for monetary stimulus. Yet the usual remedy--lower short-term nominal interest rates--is plainly unavailable. Vigorous expansion of the monetary base has also seemed to do little to stimulate demand under these circumstances: as figure l also shows, the monetary base is now more than twice as large, relative to GDP, as it was in the early 1990s. [FIGURE 1 OMITTED] In the United States, meanwhile, the federal funds rate has now been reduced to only 1 percent, and signs of recovery remain exceedingly fragile. This has led many to wonder if this country might not also soon find itself in a situation where interest rate policy is no longer available as a tool for macroeconomic stabilization. A number of other countries face similar questions. John Maynard Keynes first raised the question of what can be done to stabilize the economy when it has fallen into a liquidity trap--when interest rates have fallen to a level below which they cannot be driven by further monetary expansion--and whether monetary policy can be effective at all under such circumstances. Long treated as a mere theoretical curiosity, Keynes's question now appears to be one of urgent practical importance, but one with which theorists have become unfamiliar. The question of how policy should be conducted when the zero bound is reached--or when the possibility of reaching it can no longer be ignored--raises many fundamental issues for the theory of monetary policy. Some would argue that awareness of the possibility of hitting the zero bound calls for fundamental changes in the way policy is conducted even before the bound has been reached. For example, Paul Krugman refers to deflation as a "black hole," (1) from which an economy cannot expect to escape once it has entered. A conclusion often drawn from this pessimistic view of the efficacy of monetary policy in a liquidity trap is that it is vital to steer far clear of circumstances in which deflationary expectations could ever begin to develop--for example, by targeting a sufficiently high positive rate of inflation even under normal circumstances. Others are more sanguine about the continuing effectiveness of monetary policy even when the zero bound is reached, For example, it is often argued that deflation need not be a black hole, because monetary policy can affect aggregate spending, and hence inflation, through channels other than central bank control of short-term nominal interest rates. Thus there has been much recent discussion, with respect to both Japan and the United States--of the advantages of vigorous expansion of the monetary base even without any further reduction in interest rates, of the desirability of attempts to shift longer-term interest rates through central bank purchases of longer-maturity government securities, and even of the desirability of central bank purchases of other kinds of assets. Yet if these views are correct, they challenge much of the recent conventional wisdom regarding the conduct of monetary policy, both within central banks and among academic monetary economists. That wisdom has stressed a conception of the problem of monetary policy in terms of the appropriate adjustment of an operating target for overnight interest rates, and the prescriptions formulated for monetary policy, such as the celebrated Taylor rule, (2) are typically cast in these terms. …

Abstract: In the early years of macroeconomics as a discipline, the liquidity trap-that awkward condition in which monetary policy loses its grip because the nominal interest rate is essentially zero, in which the quantity of money becomes irrelevant because money and bonds are essentially perfect substitutes-played a central role. Hicks (1937), in introducing both the IS-LM model and the liquidity trap, identified the assumption that monetary policy was ineffective, rather than the assumed downward inflexibility of prices, as the central difference between " Mr. Keynes and the classics ". It has often been pointed out that the Alice-in-Wonderland character of early Keynesianism, with its paradoxes of thrift, widow's cruses, and so on, depended on the explicit or implicit assumption of an accommodative monetary policy; it has less often been pointed out that in the late 1930s and early 1940s it seemed quite natural to assume that money was irrelevant at the margin. After all, at the end of the 30s interest rates were hard up against the zero constraint: the average rate on Treasury bills during 1940 was 0.014 percent. Since then, however, the liquidity trap has steadily receded both as a memory and as a subject of economic research. Partly this is because in the generally inflationary decades after World War II nominal interest rates stayed comfortably above zero, and central banks therefore no longer found themselves " pushing on a string ". Also, the experience of the 30s itself was reinterpreted, most notably by Friedman and Schwartz (1963); emphasizing broad aggregates rather than interest rates or monetary base, they argued in effect that the Depression was caused by monetary contraction, that the Fed could have prevented it, and implicitly that even after the great slump a sufficiently aggressive monetary expansion could have reversed it. To the extent that modern

Abstract: This paper explains the key factors that determine the output multiplier of government purchases in New Keynesian models, through a series of simple examples that can be solved analytically. Sticky prices or wages allow for larger multipliers than in a neoclassical model, though the size of the multiplier depends crucially on the monetary policy response. A multiplier well in excess of 1 is possible when monetary policy is constrained by the zero lower bound, and in this case welfare increases if government purchases expand to partially flll the output gap that arises from the inability to lower interest rates.