Dynamic Macroeconomics

20.7 Monetary Policy, Financial Frictions, and the Zero Lower
Bound on Interest Rates
The interest rate rules we have been examining up to now assume that there
are no financial frictions and that the central bank can freely adjust the
nominal interest rate.
In chapter 19, we discussed the nature of financial frictions and how they
can result in financial crises, such as that of 2008–2009 or the Great
Depression of the 1930s. We also analyzed the macroeconomic implications
of financial frictions, using two alternative new Keynesian models, one with
staggered pricing and one with periodic nominal wage contracts. We showed
that if the central bank follows a Taylor [1993] rule for interest rates,
financial frictions that raise the external finance premium result in recessions
and deflations, in the sense that inflation falls below the optimal inflation
rate.
We also argued that the normal Taylor rule is not the optimal
macroeconomic response to a financial markets shock. The optimal
macroeconomic response would be for the central bank interest rate to
completely neutralize the rise in the external finance premium, by falling
sufficiently so as to completely avert a recession. This can be achieved if the
response of the central bank interest rate to inflation became infinitely large,
completely stabilizing the inflation rate at its optimal level. However, this
may not be possible if there is a zero lower bound on interest rates.
Prior to the Great Recession of 2008–2009, inflation was low and close
to official target rates in the advanced economies, so that short-term nominal
interest rates tended to deviate relatively little from their long-run average.

---

The only exception was Japan, where short-term nominal interest rates had
been close to zero since the 1990s. Central banks in the other industrialized
economies responded to the Great Recession by lowering key policy interest
rates to, or very close to, zero.
Because the nominal return from holding money in the form of cash is
equal to zero, it is generally accepted that central banks cannot sustain their
policy interest rates below zero, as cash can always be held as an alternative
to negative interest rate bearing assets, such as deposits or bonds. The
implication is that nominal interest rates have a zero lower bound even if the
state of the economy requires negative nominal and real interest rates to
minimize deviations of inflation from target and output and employment from
their natural rates. Hence, conventional monetary policy cannot respond
effectively to financial or other shocks that tip the economy toward the zero
lower bound.