Zero Lower Bound Research Articles

Generalizing Determinacy under Monetary and Fiscal Policy Switches: The Case of the Zero Lower Bound

AbstractIn a fixed‐regime context, it has been established since the work of Leeper (1991) that a determinate and unique equilibrium can be achieved under both monetary dominance (characterized by an active monetary policy and a passive fiscal policy) and fiscal dominance (characterized by an active fiscal policy and a passive monetary policy) regimes yield a determinate unique equilibrium. In this paper, we generalize this well‐established policy‐mix taxonomy to regime‐switching models, and show that switches from monetary dominance to fiscal dominance regimes (and vice versa) render the economy indeterminate for standard parameter values. We apply our results to the important case of the exit from the zero lower bound (ZLB), where monetary policy is inherently passive. Contrary to the fixed‐regime prediction, the economy switching between the ZLB in a fiscally led regime and a monetary dominance regime is robustly indeterminate, making the coordination of agents' beliefs hard for anchoring expected inflation. Finally, we propose a direction toward which the perspective of the fiscal theory of the price level can be made consistent with a unique stable equilibrium.

The Contribution of Foreign Holdings of U.S. Treasury Securities to the U.S. Long-Term Interest Rate: An Empirical Investigation of the Impact of the Zero Lower Bound

The Contribution of Foreign Holdings of U.S. Treasury Securities to the U.S. Long-Term Interest Rate: An Empirical Investigation of the Impact of the Zero Lower Bound

Optimal trend inflation in an open economy

We study the optimal inflation target in an open economy with a zero lower bound (ZLB) on nominal interest rates calibrated to the Euro area. When uncovered interest rate parity (UIP) holds, the optimal inflation target is smaller than in a closed economy. The key to this result is that real interest rates at the ZLB increase less as trade openness increases. This less pronounced increase in real interest rates in an open economy mitigates the contraction in aggregate demand, thus reducing the cost of ZLB. Additionally, the optimal inflation target in a monetary union is lower than in a flexible exchange rate regime: forming a monetary union results in a decrease in the optimal inflation rate by 0.24%, thereby increasing per-period welfare by 0.07%. When departures from UIP are significant, the optimal inflation target may be higher than in a closed economy, and the desirability of a monetary union increases further.

A Smooth Shadow-Rate Dynamic Nelson-Siegel Model for Yields at the Zero Lower Bound

We propose a smooth shadow-rate version of the dynamic Nelson-Siegel (DNS) model to analyze the term structure of interest rates during a zero lower bound (ZLB) period. By relaxing the no-arbitrage restriction, our shadow-rate model becomes highly tractable with a closed-form yield curve expression. This permits the implementation of readily available DNS extensions such as allowing for time-varying parameters and the integration of macroeconomic variables. Using U.S. Treasury data, we provide clear evidence of a smooth transition of the yields entering and leaving the ZLB state. Moreover, we show that the smooth shadow-rate DNS model dominates the baseline DNS model and (shadow-rate) affine term structure models in terms of fitting and forecasting the yield curve, while it also produces plausible policy insights at the ZLB.

A Structural Investigation of Quantitative Easing

Abstract Using nonlinear Bayesian methods that fully account for the binding zero lower bound (ZLB), we estimate a large-scale macrofinance DSGE model on U.S. data. Counterfactual analysis suggests that by easing financing conditions, quantitative easing facilitated a net increase in aggregate investment. The resulting expansion of firms’ production capacities lowered their marginal costs. These disinflationary supply side effects dominated over the inflationary effects induced by the stimulus to aggregate demand. At the ZLB, the concomitant rise in real interest rates, in turn, induced a net fall in aggregate consumption.

Uncertainties, Employment and the Zero Lower Bound

Uncertainties, Employment and the Zero Lower Bound

Fiscal stimulus with imperfect expectations: Spending vs. tax policy

This paper addresses the question: how sensitive is the power of fiscal policy at the Zero Lower Bound (ZLB) to the assumption of rational expectations? We do so through the lens of a standard New Keynesian model in which people are dynamic level-k thinkers. Our analysis weakens the case for using government spending to stabilize the economy when the ZLB binds. The less sophisticated people are, the smaller the government-spending multiplier is. Our analysis strengthens the case for using tax policy to stabilize output when the ZLB is binding. The power of tax policy to stabilize the economy during the ZLB period is essentially undiminished when agents do not have rational expectations. Our results are robust to whether or not Ricardian equivalence holds. Finally, we show that the way in which tax policy is communicated is critical to its effectiveness.

Fed and ECB reaction functions during quantitative easing: Three phases of monetary policy, both conventional and unconventional

Studying monetary authority response to macroeconomic imbalances using the interest rate as a proxy variable for monetary policy became ineffective after the financial crisis, when central banks exhausted the effective capacity of interest rates by reaching the zero lower bound (ZLB). In an effort to analyse the unconventional response deployed by central banks, we present and estimate a modified reaction function that uses money supply as the operational instrument of monetary policy for the Federal Reserve and the European Central Bank, and we verify its utility as an explanatory instrument for the behaviour of the two monetary authorities. By applying our strategy, it is feasible to identify both monetary policy reaction with regard to the economic situation as well as other possible monetary authority concerns regarding governments’ fiscal behaviour and the evolution of asset markets, regardless of the monetary policy applied at any given time.

The Deflationary Bias of the ZLB and the FED's Strategic Response

AbstractThe paper shows, in a simple analytical framework, the existence of a deflationary bias in an economy with a low natural rate of interest, a zero lower bound (ZLB) constraint on nominal interest rates and a discretionary Central Bank (CB) with an inflation mandate. The presence of the ZLB prevents the CB from offsetting negative shocks to inflation whereas it can offset positive shocks. This asymmetry pushes average inflation below the target which in turn drags down inflation expectations and reinforces the likelihood of hitting the ZLB. We show that this deflationary bias is particularly relevant for a CB with a symmetric dual mandate (i.e., minimizing deviations from inflation and employment), especially when facing demand shocks. But a strict inflation targeter cannot escape the suboptimal deflationary equilibrium either. The deflationary bias can be mitigated by targeting “shortfalls” instead of “deviations” from maximum employment and/or using flexible average inflation targeting. However, changing monetary policy strategy risks inflation expectations becoming entrenched above the target if the natural interest rate increases.

Changes and Impact of Monetary Policy in the United States: Quantitative Easing and Federal rate hikes

In response to the 2008 financial crisis, marked by the collapse of Wall Street giants like Bear Stearns and Lehman Brothers, the U.S. faced significant economic challenges. Traditional monetary policy tools proved ineffective as interest rates neared the Zero Lower Bound. Consequently, the Federal Reserve implemented Quantitative Easing (QE) as an unconventional measure to stimulate financial markets. This policy was executed in four phases, and by the end of the fourth round, U.S. inflation rates surpassed the 2022 target. Elevated inflation impacted living standards, prompting the FED to introduce interest rate hikes in 2022 to control it. Supply chain disruptions were a major contributor to this inflation spike. This paper uses qualitative and statistical methods to explore QE and the subsequent FED rate hikes. It emphasizes that QE essentially expanded the FED's Balance Sheet and uses visual data like graphs to illustrate the FED's actions since 2022. The article provides a comprehensive view of U.S. monetary policy adaptations during and after the financial crisis. The first three QE rounds addressed the 2008 crisis aftermath, while QE4 combated the economic fallout of COVID-19. The 4 rounds of QE and the last 2 years of Fed rate hikes have been generally successful. Both monetary policies have had some proven effect on the US economy. However, by critical thinking, QE has potential downsides, like fostering economic bubbles and inflation. And the Fed's repeated interest rate hikes have led to the problem of bank failure. Therefore, the Fed's monetary policy choices, especially unconventional ones like QE, require weighing benefits against potential risks.

Quantitative Easing’s Effects on the U.S. Housing Market

As the housing bubble burst in the United States, the buildup of subprime lending led to the Global Financial Crisis. The Federal Reserve desperately slashes interest rates to reverse the economic recession, but the Zero Lower Bound significantly hindered the policy's future effectiveness with concerns of an existing liquidity trap. As a result, the unprecedented Quantitative Easing became the policymakers' last resort. Through the large-scale purchases of financial assets including mortgage-backed securities (MBS) and government bonds, the Fed attempts to stimulate the economy through reserve creation and instilling downward pressure on future interest rates. This literature review discusses how QE specifically affected the U.S. housing market during the GFC. An analysis is conducted on various social aspects and stakeholders by identifying the various channels through which QE is transmitted. The signaling, bank lending, and refinancing channels all suggest that MBS had the greatest effect on market expectations, bank behaviors, and consumer spending. As a result, many were many spillover effects into real estate, notably on asset prices, employment, and investment. Even though literature has criticized QE's ineffectiveness and its potential drawbacks, the unconventional monetary policy certainly played an essential role in preventing a worse outcome and effectively demonstrating its ability to reduce interest rates, generate wealth, and revive the economy.

Determinacy and E‐Stability with Interest Rate Rules at the Zero Lower Bound

AbstractWe evaluate and compare alternative interest rate rules, namely, average inflation targeting (AIT), price‐level targeting (PLT), and traditional inflation targeting rules, in a standard New Keynesian model that features recurring, transient zero lower bound regimes. We use determinacy and expectational stability (E‐stability) of equilibrium as the criteria for stabilization policy. We find that PLT policy, including nominal GDP targeting as a special case, most effectively promotes determinacy and E‐stability among the policy frameworks, whereas standard inflation targeting rules are prone to indeterminacy. AIT can induce determinacy and E‐stability effectively, provided the averaging window is sufficiently long.

Bank lending policies and monetary policy: some lessons from the negative interest era

Abstract What is the long-term impact of negative interest rates on bank lending? To answer this question, we construct a unique summary measure of negative rate exposure by individual banks based on exclusive survey data and banks’ balance sheets and couple it with the credit register of Spain and firms’ balance sheets to identify this impact on the supply of credit to firms. We find that only when deposit rates reached the zero lower bound did affected banks (relative to non-affected banks) decrease their supply, especially when undercapitalized and lending to risky firms. The adverse effects of the negative rates on banks’ intermediation capacity only took place after a protracted period of time.

Bond Risk Premiums at the Zero Lower Bound

Bond Risk Premiums at the Zero Lower Bound

Effects of Unconventional Monetary Policy at the Zero Lower Bound

Effects of Unconventional Monetary Policy at the Zero Lower Bound

Stock market response to public investment under the zero lower bound: Cross-industry evidence from Japan

This study examines the effects of public investment on the stock market between the zero lower bound (ZLB) and the non-ZLB periods using Japanese sectoral panel data. The empirical results first show that while public investment shocks have stimulating effects on stock returns during the ZLB period, this is not the case outside of the ZLB. Furthermore, the impulse responses for the manufacturing industry are estimated to be positive and significant regardless of model specification. Our results suggest that the government is recommended to increase public investment under the ZLB to prop up the stock market but cut back once the economy is no longer in a liquidity trap.

How Oil Shocks Propagate: Evidence on the Monetary Policy Channel

Using high-frequency responses of oil futures prices to prominent oil market news, we estimate the effects of oil supply news shocks when systematic monetary policy is switched off by the zero lower bound (ZLB) and when it is not (normal periods) in Japan, the United Kingdom, and the United States. We find that negative oil supply news shocks are less contractionary (and even expansionary) at the ZLB compared to normal periods. Inflation expectations increase during both periods, while the short nominal interest rates remain constant at the ZLB, pointing to the importance of monetary policy for oil shock propagation.

Estimating a Behavioral New Keynesian Model with the Zero Lower Bound

AbstractWe estimate a New Keynesian model incorporating two notable features: bounded rationality and the zero lower bound on the nominal interest rate. Our Bayesian estimation of a nonlinear model shows that the model with bounded rationality better fits the U.S. data than its rational expectations counterpart, and that both households and firms exhibit a substantial degree of bounded rationality. Moreover, we demonstrate that bounded rationality expands a parameter region in which the model can be estimated and weakens the power of forward guidance.

Exiting from quantitative easing in an era of large government debt: Inflation or default?

Japanese government bonds have accumulated during the last decades, while the Bank of Japan has purchased government bonds under the Quantitative and Qualitative Monetary Easing. This note reconsiders a relationship between inflation stability and a government bond default by using a simple model in which the fiscal authority: (ⅰ) commits not to making fiscal adjustments needed to stabilize government debt, (ⅱ) commits not to providing financial support for the central bank that incurs losses on its balance sheet, and (ⅲ) can partially default on government bonds. We show that the central bank that engages in large-scale purchases of long-term government bonds when the zero lower bound (ZLB) binds cannot achieve its inflation target after the ZLB is no longer binding.

Existence and Uniqueness of Solutions to Dynamic Models with Occasionally Binding Constraints

Abstract Occasionally binding constraints (OBCs) like the zero lower bound (ZLB) can lead to multiple equilibria, and so to belief-driven recessions. To aid in finding policies that avoid this, we derive existence and uniqueness conditions for otherwise linear models with OBCs. Our main result gives necessary and sufficient conditions for such models to have a unique (“determinate”) perfect foresight solution returning to a given steady state, for any initial condition. While standard New Keynesian models have multiple perfect-foresight paths eventually escaping the ZLB, price level targeting restores uniqueness. We also derive equilibrium existence conditions under rational expectations for arbitrary nonlinear models.