Comments and Discussion

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 1 also shows, the monetary base is now more than twice as large, relative to GDP, as it was in the early 1990s.

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

Figure 1.

Japan: Call Rate on Overnight Loans and Ratio of Monetary Base to GDP, 1990–2002

Source: Nomura database, Bank of Japan.

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...