lowering the interest rate. why is it not possible to reduce the nominal interest rate below zero? the reason is that money in the form of banknotes and coins yields a zero interest rate. if the interest rates for various accounts and securities such as treasury bills and bonds were to become negative, households, firms and authorities would prefer to retain cash in the form of banknotes instead of lending it or depositing it. with a zero interest rate, households, firms and authorities become indifferent about the choice of whether to hold securities such as treasury bills and bonds or to hold cash. 2 a so - called open market operation in which the central bank increases the monetary base and thus liquidity by buying treasury bills and bonds and paying with cash, then becomes ineffective in the sense that the interest rate is still zero and the only thing that happens is that households, firms and authorities hold more cash and fewer treasury bills and bonds. a situation with a zero interest rate is therefore also called a liquidity trap. the issue of monetary policy when the interest rate is zero has become topical again. since the autumn of last year, the outlook for the global economy has deteriorated further. at the same time as forecasts for inflation and growth have been revised downwards, policy rates for more information on these measures, see www. riksbank. se. this applies when the amount of cash held does not fall below the level needed for transaction purposes. have been lowered and are now approaching zero in several countries. in december last year, the federal reserve, for example, cut its policy rate to an interval between 0 – 0. 25 per cent, while in japan the policy rate is 0. 1 per cent and in switzerland 0. 5 per cent. inflation throughout the world is also falling rapidly. it is possible that the level of inflation can become negative and that we will thus see deflation in some countries. deflation for a short period is not a major problem. we even had this in sweden a few years ago. but if deflation is prolonged, and especially if inflation expectations fall and deflation expectations arise, the situation can become very problematic. the combination of very low policy rates, a weak real economy and the risk of deflation has thus revived the debate about how monetary policy can and should be conducted in the event of a zero interest rate bound. in the 1990s, japan experienced a long period with a zero interest rate, deflation and, compared with previous decades, weak real economic development. the experience

parity condition, the current exchange rate is determined by the expected future exchange rate, current and expected future interest rate differentials between domestic and foreign interest rates and expected future currency risk premia. the future exchange rate depends on future price level, the future real exchange rate and future foreign price level. for exchange rates and price levels expressed in logarithms we can specify the following relation : current exchange rate = expected future ( exchange rate – interest rate differential + foreign exchange risk premium ) = expected future ( price level + real exchange rate – foreign price level – interest rate differential + foreign exchange risk premium ) with an expected future domestic interest rate that is zero or low, future interest rate differentials and foreign exchange risk premia for a small open economy are largely exogenous and given. at a reasonably long horizon, the expected future real exchange rate is given by a neutral real equilibrium rate and is largely exogenous for a small economy. the expected future foreign price level is also exogenous for a small open economy. consequently, under these conditions, the expected future price level is practically the only endogenous variable that affects the current exchange rate. with this reasoning, the current exchange rate, all other things being equal, becomes a direct indicator of the expected future price level. by observing the exchange rate, the central bank can thus observe expectations of the future price level. higher inflation expectations and thereby a higher expected future price level lead then to a depreciation of the currency today, all else being equal. a measure that raises expectations of future inflation and the future price level should thus show up in a depreciated currency. a strengthening of the currency may therefore be ominous and interpreted as a sign that inflation expectations are falling. 11 www. rba. gov. au. a well - argued proposal on a combination, a hybrid, between a price level target and an inflation target is presented in giavazzi, f and mishkin, f. s. ” an evaluation of swedish monetary policy 1995 - 2005 ”. ( 2006 / 07 : rfr1 ), www. riksdagen. se. see equations ( 8 ) and ( 9 ) and more details in the appendix to this speech. the exchange rate as a policy instrument – " the foolproof way " to escape a liquidity trap the direct link between the current exchange rate and the expected future price level first leads, as mentioned, to the insight that the current exchange rate depends on the