the central bank is poorly positioned to respond to further negative demand shocks. because of the zero bound, it is impossible for nominal interest rates to decline further, but it is still possible for inflation to decline to below zero - - that is, for deflation to set in. the combination implies that real interest rates may actually start to rise in the face of negative demand shocks. in this range, the central bank loses much of its ability to respond to these negative demand shocks by lowering real rates of interest. as many have pointed out, the central bank could still respond to negative demand shocks by expanding money growth in various " nontraditional " ways. but these nontraditional approaches are untested. macro - model simulations indicate that if the central bank exercises only traditional policy instruments, the zero - bound problem could significantly increase the severity of recessions. the virulence of the japanese recession also suggests that zerobound problems could be serious. today the standard thinking is that the central bank can and should avoid dealing with these difficulties by guiding the economy toward a low, positive rate of inflation, not a zero rate. the second argument for avoiding mathematical zero involves labor markets. a good deal of evidence suggests that, in the economy at large, employers are reluctant to cut workers'nominal wages or, at least, downward wage rigidities exceed upward rigidities. the normal market process of reallocation of labor in response to industry or sectoral shifts works by having real wages adjust to keep them in line with workers'marginal products of labor. if nominal wages cannot be cut for workers who, for whatever reason, become less productive, labor market flexibility is enhanced by having low positive overall rates of inflation that effectively cut real wages for these workers. to these strategic reasons for avoiding mathematical zero can be added a measurement reason. one of the great difficulties in compiling price indexes is in adjusting them for changes in the quality of goods and services. how does one measure the value of a new good or of a service that benefits from a new technology? casual evidence indicates that failure to make accurate adjustments can create a bias that could be quite large - - indeed, king ( 2002 ) gives some heuristic illustrations that suggest that the true prices of some consumer durables have not risen at all since as far back as 1915! the statistical agencies compiling consumer prices in the united states - - the bureau of labor statistics for the consumer price index ( cpi ) and the department of commerce for the personal consumption expenditure def

edward m gramlich : maintaining price stability remarks by mr edward m gramlich, member of the board of governors of the us federal reserve system, before the economic club of toronto, toronto, canada, 1 october 2003. the references for the speech can be found on the board of governors of the federal reserve system ’ s website. * * * one of the remarkable economic developments of the past two decades is the sharp, worldwide reduction in rates of inflation. before the 1980s, research papers, economic commentary, and textbooks here and abroad were full of discussions of the causes and consequences of high inflation and of the political difficulty of bringing it under control. it looked then like inflation had become a more or less permanent feature of the economic landscape. concepts associated with deflation such as liquidity traps and the zero bound on nominal interest rates had, for practical purposes, disappeared from economic thought. but, beginning around 1980, central banks around the world seem to have ganged up on inflation, fought the fight, and won. the international monetary fund's consumer price index for industrial countries registered an annual rate of inflation exceeding 12 percent in 1980, but by 2002 the rate had dropped to just 1. 4 percent. in the united states, consumer price inflation excluding food and energy fell from 12. 4 percent in 1980 to 2. 4 percent in 2002. japan has actually had negative rates of inflation for the past four years. the drop in inflation in many prominent emerging - market countries has been even more breathtaking ( rogoff, 2003 ). perhaps just as remarkable as the abrupt fall in worldwide inflation is the widespread agreement on the reasons for its fall. virtually all economic analysts would give a primary role to the implementation of plain old economic theory. macroeconomists had long understood that, in the famous words of milton friedman, " inflation is everywhere and always a monetary phenomenon. " but somehow this theoretical agreement never was translated into action. perhaps because of advances in understanding the inflation process, perhaps because of worrisome increases in inflation rates, perhaps because of a discovery that the economic costs of fighting inflation were not as high as previously believed, central bankers in the 1980s suddenly began to use their monetary control to limit the rate of increase in prices. it is not stretching things to call this a revolution in central banking. now that something like price stability has arrived, two important policy questions present themselves : · is a mere determination to achieve price stability adequate for central banks to stabilize prices, or should their