Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment

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Abstract
The conventional instrument of monetary policy in most major industrial economies is the very short term nominal interest rate, such as the overnight federal funds rate in the case of the United States. The use of this instrument, however, implies a potential problem: Because currency (which pays a nominal interest rate of zero) can be used as a store of value, the short-term nominal interest rate cannot be pushed below zero. Should the nominal rate hit zero, the real short-term interest rate—at that point equal to the negative of prevailing inflation expectations—may be higher than the rate needed to ensure stable prices and the full utilization of resources. Indeed, an unstable dynamic may result if the excessively high real rate leads to downward pressure on costs and prices that, in turn, raises the real short-term interest rate, which depresses activity and prices further, and so on.

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