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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.

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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File URL: http://hdl.handle.net/1866/374
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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
Date of revision:
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. Pesaran, M. Hashem & Samiei, Hossein, 1995. "Limited-dependent rational expectations models with future expectations," Journal of Economic Dynamics and Control, Elsevier, vol. 19(8), pages 1325-1353, November.
  2. RUGE-MURCIA, Francisco J., 1998. "Uncovering Financial Markets Beliefs About Inflation Targets," Cahiers de recherche 9803, Universite de Montreal, Departement de sciences economiques.
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  11. Pesaran, M Hashem & Ruge-Murcia, Francisco J, 1999. "Analysis of Exchange-Rate Target Zones Using a Limited-Dependent Rational-Expectations Model with Jumps," Journal of Business & Economic Statistics, American Statistical Association, vol. 17(1), pages 50-66, January.
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  17. Cecchetti, Stephen G, 1988. "The Case of the Negative Nominal Interest Rates: New Estimates of the Term Structure of Interest Rates during the Great Depression," Journal of Political Economy, University of Chicago Press, vol. 96(6), pages 1111-41, December.
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Cited by:

  1. Ruge-Murcia, Francisco J., 2006. "The expectations hypothesis of the term structure when interest rates are close to zero," Journal of Monetary Economics, Elsevier, vol. 53(7), pages 1409-1424, October.
  2. J. De Dios Tena & E. Otranto, 2008. "A Realistic Model for Official Interest Rates," Working Paper CRENoS 200802, Centre for North South Economic Research, University of Cagliari and Sassari, Sardinia.
  3. 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.

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