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Some Implications of the Zero Lower Bound on Interest Rates for the Term Structure and Monetary Policy

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RUGE-MURCIA, Francisco J.

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Abstract

In an economy where cash can be stored costlessly (in nominal terms), the nominal interest rate is bounded below by zero. This paper derives the implications of this nonnegativity constraint for the term structure and shows that it induces a nonlinear and convex relation between short- and long-term interest rates. As a result, the long-term rate responds asymmetrically to changes in the short-term rate, and by less than predicted by a benchmark linear model. In particular, a decrease in the short-term rate leads to a decrease in the long-term rate that is smaller in magnitude than the increase in the long-term rate associated with an increase in the short-term rate of the same size. Up to the extent that monetary policy acts by affecting long-term rates through the term structure, its power is considerably reduced at low interest rates. The empirical predictions of the model are examined using data from Japan.

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Paper provided by Universite de Montreal, Departement de sciences economiques in its series Cahiers de recherche with number 2002-06.

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Length: 31 pages
Date of creation: 2002
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Handle: RePEc:mtl:montde:2002-06

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Keywords: limited-dendent rational-exctations models; nonlinear forecasting; monetary licy; Jan;

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  1. Ben S. Bernanke & Vincent R. Reinhart & Brian P. Sack, 2004. "Monetary policy alternatives at the zero bound: an empirical assessment," Finance and Economics Discussion Series 2004-48, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
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