We consider the consequences for monetary policy of the zero floor for nominal interest rates. The zero bound can be a significant constraint on the ability of a central bank to combat deflation. We show, in the context of an intertemporal equilibrium model, that open-market operations, even of unconventional' types, are ineffective if they do not change expectations about the future conduct of policy; in this sense, a liquidity trap' is possible. Nonetheless, a credible commitment to the right sort of history-dependent policy can largely mitigate the distortions created by the zero bound. In our model, optimal policy involves a commitment to adjust interest rates so as to achieve a time-varying price-level target, when this is consistent with the zero bound. We also discuss ways in which other central-bank actions, while irrelevant apart from their effects on expectations, may help to make credible a central bank's commitment to its target, and consider implications for the policy options currently available for overcoming deflation in Japan.
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number
9968.
Length: Date of creation: Sep 2003 Date of revision: Handle: RePEc:nbr:nberwo:9968
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Find related papers by JEL classification: E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
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