Optimal Monetary Policy in a Liquidity Trap ∗

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. ∗Prepared for the International Workshop on Overcoming Deflation and Revitalizing the Japanese Economy, Economic and Social Research Institute, Tokyo, September 18, 2003. Parts of this paper have previously appeared in Eggertsson and Woodford (2003). We would like to thank Tamim Bayoumi, Ben Bernanke, Robin Brooks, Michael Dotsey, Martin Feldstein, Benjamin Friedman, Stefan Gerlach, Mark Gertler, Marvin Goodfriend, Kenneth Kuttner, Maurice Obstfeld, Athanasios Orphanides, Kenneth Rogoff, David Small, Lars Svensson, Harald Uhlig, Tsutomu Watanabe, and Alex Wolman for helpful comments, and the National Science Foundation for research support through a grant to the NBER. The views expressed in this paper are those of the authors and do not necessarily represent those of the IMF or IMF policy. The consequences for the proper conduct of monetary policy of the existence of a lower bound of zero for overnight nominal interest rates has recently become a topic of lively interest. The relevance of this bound is nowhere more apparent than in the case of Japan, where the call rate (the overnight cash rate that is analogous to the federal funds rate in the U.S.) has been essentially at zero for most of the time since February 1999, when the policy board of the Bank of Japan decided to make it “as low as possible”. (As shown in Figure 1, the call rate has actually been at or below 50 basis points since October 1995, so that little room for further reductions in short-term nominal interest rates has existed since that time.) At the same time, growth has remained anemic in Japan over this period, and prices have continued to fall, suggesting to many observers a need for further monetary stimulus. Yet the usual remedy — lower short-term nominal interest rates — is plainly unavailable. This has led to interest in policies that might bring about further monetary stimulus, even taking as given the BOJ’s “zero interest rate policy” (ZIRP). Since March 2001, the BOJ has supplemented the ZIRP with a policy of “quantitative easing,” in which the supply of reserves to the banking system is increased beyond the level required in order to keep the call rate at zero. But even quite vigorous expansion of the monetary base (which, as shown in the figure, is now more than twice as large, relative to GDP, as in the early 1990s) has not as of yet been able to halt the deflation. This suggests that Japan is currently experiencing a “liquidity trap” of the kind hypothesized by Keynes (1936), though the practical possibility of such a situation continued for decades to be debated. The result is that a problem that was long treated as a mere theoretical curiosity — the question of what, if anything, monetary policy could do to halt deflation under such circumstances — now appears to be one of urgent practical importance. See Kimura et al. (2002) for discussion of this policy, as well as an expression of doubts about its effectiveness. Hetzel (2003) argues that there is no liquidity trap in Japan, on the ground that the public’s holdings of M2 plus CDs remains only a little higher than an estimated demand function estimated using earlier data would have predicted; “there is no mushrooming demand indicative of a liquidity trap” (p. 32). But one should not expect to see “mushrooming demand” for money holdings on the part of the public, if the BOJ has no way of forcing the creation of additional M2. The monetary base is substantially higher now than a demand function estimated on data prior to 2001 would have predicted (see, e.g., Kimura et al., 2002), and this is what the BOJ policy of “quantitative easing” requires the private sector to hold more of.