MONETARY ECONOMICS

Monetary economics

Monetary economics

Explain what is meant (in monetary policy) by the 'zero lower bound problem'.

It has long been believed that hitting the zero lower bound (ZLB) for the policy rate would greatly reduce the ability of the monetary authority to stabilize the economy. Until as recently as 2007, however, the mainstream consensus was that it would be an extremely rare event, so that no one had to worry about it. Views have changed (Lown, 2006, p1575).

When, in April 2009, the policy rate fell to 25 basis points, which was deemed to be the effective ZLB, the Bank of Canada outlined a series of actions that it would take, if needed, to achieve its inflation target. At the end of the day, it engaged only one of these nonstandard actions: a "conditional commitment" to keep the policy rate fixed at the effective ZLB until the end of June 2010. The commitment was conditional on the inflation outlook, and Bank officers went to great lengths to remind markets that the policy rate would be raised if it was judged that not doing so would lead to a path for inflation that would overshoot the Bank's 2 percent target.

The initial impact of the announcement of the conditional commitment on the yield curve was small, and it is unlikely that it did very much to encourage firms or households to spend more. As the recovery gathered steam, however, the conditional commitment helped assuage fears that the monetary authority would start to raise the policy rate from its emergency low level. It would be hard to capture the evidence formally, but I observed that good news in late 2009 and early 2010 often led rates farther along the maturity or risk curve to creep up. But a reminder from a senior officer that the Bank of Canada stood behind its conditional commitment was usually followed by a quick reversal of this increase. By contributing to keep the yield curve from drifting higher during its early phase, the conditional commitment accelerated the recovery (Lenza, 2010, p295).

While helpful in reducing uncertainty about the short-run path of the policy rate, the conditional commitment left some important questions unanswered. What would lead to an exit before the end of June 2010? As the Bank made clear, the outlook for inflation had to change, but by how much? Some of the uncertainty was undoubtedly related to being in an unfamiliar place for the first time, but some was inherent in the vagueness of the notion of what constituted a substantive change in the inflation outlook (Lown, 2006, p1575).

While I argued above that the difference between IT - with history dependence, as practised by the Bank - and price-level- targeting (PLT) was relatively unimportant during normal times, the potential advantages of price-level- targeting appear prominently when the economy hits the ZLB. Under price-level- targeting (PLT), if the economy hits the ZLB at the same time that inflation is low, the Bank is committed to producing inflation above the target 2 percent ...