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Interest rates as options: assessing the markets' view of the liquidity trap


  • Antulio N. Bomfim


Nominal short term interest rates have been low in the United States, so low that some have wondered whether the federal funds rate is likely to hit its lower bound at 0 percent. Such a scenario, which some economists have called the liquidity trap, would imply that the Federal Reserve could no longer lower short-term interest rates to counter any deflationary tendencies in the economy. In this paper, I use an affine term structure model to infer what interest rates tell us about the probability, as assessed by financial market participants, of such an event taking place. I also examine whether U.S. short-term rates have been low enough to distort the shape of the yield curve.

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  • Antulio N. Bomfim, 2003. "Interest rates as options: assessing the markets' view of the liquidity trap," Finance and Economics Discussion Series 2003-45, Board of Governors of the Federal Reserve System (U.S.).
  • Handle: RePEc:fip:fedgfe:2003-45

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    References listed on IDEAS

    1. Vasicek, Oldrich, 1977. "An equilibrium characterization of the term structure," Journal of Financial Economics, Elsevier, vol. 5(2), pages 177-188, November.
    2. Babbs, Simon H. & Nowman, K. Ben, 1999. "Kalman Filtering of Generalized Vasicek Term Structure Models," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 34(01), pages 115-130, March.
    3. Pierluigi Balduzzi & Sanjiv Ranjan Das & Silverio Foresi, 1998. "The Central Tendency: A Second Factor In Bond Yields," The Review of Economics and Statistics, MIT Press, vol. 80(1), pages 62-72, February.
    4. Black, Fischer, 1995. " Interest Rates as Options," Journal of Finance, American Finance Association, vol. 50(5), pages 1371-1376, December.
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    Cited by:

    1. Christensen, Jens H.E. & Lopez, Jose A. & Rudebusch, Glenn D., 2015. "A probability-based stress test of Federal Reserve assets and income," Journal of Monetary Economics, Elsevier, vol. 73(C), pages 26-43.
    2. Ben S. Bernanke & Vincent R. Reinhart & Brian P. Sack, 2004. "Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 35(2), pages 1-100.
    3. Krippner, Leo, 2013. "Measuring the stance of monetary policy in zero lower bound environments," Economics Letters, Elsevier, vol. 118(1), pages 135-138.
    4. Lemke, Wolfgang & Vladu, Andreea L., 2016. "Below the zero lower bound: A shadow-rate term structure model for the euro area," Discussion Papers 32/2016, Deutsche Bundesbank.
    5. Kortela, Tomi, 2016. "A shadow rate model with time-varying lower bound of interest rates," Research Discussion Papers 19/2016, Bank of Finland.

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    Interest rates ; Federal funds rate;

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