Academic journal article National Institute Economic Review

The Zero Interest Rate Floor (ZIF) and Its Implications for Monetary Policy in Japan

Academic journal article National Institute Economic Review

The Zero Interest Rate Floor (ZIF) and Its Implications for Monetary Policy in Japan

Article excerpt

This paper uses the IMF's macroeconomic model MULTIMOD to examine the implications of the zero interest rate floor (ZIF) for the design of monetary policy in Japan. Similar to findings in other studies, targeting rates of inflation lower than 2.0 per cent significantly increases the likelihood of the ZIF becoming binding. Systematic monetary policy strategies that respond strongly to stabilise output and inflation, or that incorporate some explicit price-level component, can help to mitigate the implications of the ZIF.

I. Introduction

Summers (1991) predicted that the issue of the zero-interest-rate floor (ZIF) would become of central importance to monetary policy in an era of low inflation. He cautioned that the scope for adjusting the stance of monetary policy could become severely constrained if the monetary authorities pursued a very low inflation rate because such a choice would result in a low average level of nominal interest rates. Specifically, in a period where interest rates were already at low levels the ZIF might significantly reduce the monetary authority's scope to reduce real interest rates when its output and inflation stabilisation objectives were threatened by adverse deflationary shocks to the economy. The experience in Japan since the mid-1990s and more recent concerns in several other industrial countries have proved Summers' prediction to be correct.

Not surprisingly, given the events in Japan in the 1990s, considerable research effort has been devoted to the implications of the ZIF. This work has followed two different tracks. The first track has examined what other policy channels, besides the short-term nominal interest rate, are available to stimulate the economy once the ZIF becomes binding. (1) The second track has investigated how the design of the monetary policy framework (as summarised by policy rules and the choice of the target rate of inflation) can affect the probability that the ZIF will become a binding constraint on policy. (2) The work presented in this paper follows both of these two tracks. One major difference, however, is that rather than using a closed-economy model to investigate this issue, this paper employs the Japan block of MULTIMOD, the IMF's multicountry macroeconomic model. (3)

Following the research track that examines policy channels other than the short-term nominal interest rate, we consider one-off fiscal and monetary policy interventions designed to help stimulate the economy after persistent negative shocks have pushed interest rates down to the ZIF. We consider an increase in government spending because expansionary fiscal policy is often argued to be an effective means of stimulating the economy once monetary policy has become less effective as a result of the ZIF. The first monetary policy intervention that we consider is a credible commitment on the part of the monetary authority to restore any decline in the price level that has occurred because the short-term nominal interest rate has been constrained by the ZIF. This monetary policy intervention can be thought of as a commitment to future inflation. This solution is suggested in Krugman (1998a,b) and is examined in Reifschnieder and Williams (1999). The second monetary policy intervention involves a sharp depreciation in the nominal exchange rate coupled with a credible commitment to achieve a specified price-level target over the medium term. This monetary policy approach to the problem of the ZIF is proposed in Svensson (2000). (4)

The one-off fiscal and monetary policy interventions that we consider are effective in stimulating the economy once the ZIF has become binding. These interventions reduce the length of time that the constraint binds and thereby reduce the output loss that is incurred. However, there are important differences that arise in the evolution of the government's debt-to-GDP ratio that make monetary-policy-based interventions more attractive; in both monetary-induced interventions the government's debt-to-GDP ratio is lower than in the scenario where the intervention is based on a fiscal expansion. …

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