Dynamic Macroeconomics

20.7.3 The Zero Lower Bound and Unconventional Monetary Policy
Is there scope for additional action from monetary policy in such a case?
Krugman [1998] and Eggerstsson and Woodford [2003] have suggested a
potential solution that rests on the central bank announcing that it will not
return to its inflation target 
π
*
(at least in the immediate future) and that future
inflation will be above target. For example, assume that the central bank
announced that its inflation target for 
t
+ 1 would be high enough that the
nominal interest rate in 
(20.46)
 is positive, despite the shock to the external
finance premium. If that was credible, then from 
(20.46)
, the recession would
be avoided, as the current real interest rate, including the external finance
premium, would become equal to the natural rate.
19
Obviously, if 
π
*
is the optimal inflation rate, then implementing a policy
such as that implied by the above discussion would not result in optimal
future inflation.
The upshot of this analysis is that managing expectations about future
inflation is potentially an important form of unconventional monetary policy
at the zero lower bound. The announcement of higher future inflation targets,
even temporarily, is a form of unconventional monetary policy called
forward guidance
. As central banks cannot use conventional monetary policy
to further reduce short-term nominal interest rates below the zero lower
bound, they are using announcements about future monetary policy to affect
current expectations about future inflation and thus affect real interest rates;
aggregate demand; and through aggregate demand, aggregate income and
employment.
To be more credible, forward guidance must be accompanied by action.
At the zero lower bound, open market operations (such as further purchases
of short-term securities by the central bank) would have no further effect on
short-term nominal interest rates. Thus, even if the central bank expands the
money supply, the additional money is willingly held by the public, because
it is considered a perfect substitute for short-term bonds, which pay an
interest rate of zero.
An additional unconventional way in which policy can attempt to
stimulate the economy is by direct intervention in credit markets that would
affect the external finance premium. In 2008 and 2009, the Federal Reserve
and other central banks took actions aimed at the markets for specific types
of credit, supporting commercial-paper issuance, mortgage lending, and so

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on. Such actions are clearly most likely to be effective when the particular
markets they are aimed at have been disrupted, as in the case of a financial
crisis.
The appropriate response of monetary policy is to increase liquidity in
order to increase bank lending and reduce interest rates, thereby reversing
the effects of the financial crisis and the rise in the external finance premium
on aggregate demand. In addition, central banks may be required to act as
lenders of last resort to the banking system and to bail out banks, in order to
prevent deleveraging, bankruptcies, and further reduction in aggregate
demand, output, and employment.
The policy of continuing to expand the money supply at the zero lower
bound is usually called quantitative easing and is a policy that was widely
adopted in the aftermath of the financial crisis of 2008–2009, when interest
rates reached the zero lower bound. By increasing the money supply,
quantitative easing makes the commitment to higher future inflation, through
forward guidance, more credible.
Another possible way for the central bank to provide stimulus in the face
of the zero lower bound is to purchase assets other than short-term
government debt in its open market operations. This is another form of
unconventional monetary policy, called 
asset purchases
. For example, the
central bank can purchase long-term government debt or corporate debt, both
of which are likely to offer positive nominal returns even when the interest
rate on short-term government debt is zero. One can envisage such
transactions as conventional open market operations, followed by exchanges
of short-term zero-interest government debt for the alternative asset. Such
open market operations can reduce long-term rates and the external finance
premium directly. These operations thus affect aggregate demand, even when
short-term interest rates are at the zero lower bound. Open market operations
that involve buying assets other than short-term government debt are an
additional form of quantitative easing.
20
Another type of unconventional open market operation that has attracted
considerable attention is exchange market intervention (Svensson [2001]).
By purchasing foreign currency or other foreign assets, the central bank can
presumably cause the domestic currency to depreciate. An exchange rate
depreciation will also stimulate aggregate demand and increase output and
employment.

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In conclusion, the zero lower bound and financial frictions are serious
issues that are likely to constrain monetary policy under particular
circumstances, such as a financial crisis. The recent experience of the 2008–
2009 financial crisis, and its theoretical analysis, have provided important
lessons about unconventional forms of monetary policy and its effects and
also revived interest in the use of fiscal policy as a tool for stabilizing the
economy.
21
We shall return to how the financial crisis of 2008–2009 has affected not
only the analysis of monetary policy but also macroeconomic modeling in
general in chapter 23.