Monetary Policy When Interest Rates Are Bounded at Zero

Working Paper 94-1
by Jeffrey C. Fuhrer and Brian Madigan
1994 Series

Revised article published in Review of Economics and Statistics 79 (November 1997): 573-585.

This article assesses the importance of the zero lower bound on nominal interest rates for the conduct of monetary policy. The article employs a small, forward-looking model developed by Fuhrer and Moore. The model is simulated under several policy rules that involve either high- or low-inflation targets. We determine the extent to which the zero bound on nominal interest rates prevents real interest rates from falling in response to negative spending shocks, and thus cushioning aggregate output, when zero inflation results in low nominal rates.

In general, the results suggest that real long-term interest rates drop considerably in response to an adverse spending shock under a variety of policy rules and inflation rates. The extent of the decline in long real rates, and thus the ability of monetary policy to cushion such shocks, generally depends to only a modest extent on the level of inflation. For relatively small and short-lived spending shocks, as well as for permanent and large shocks, the path of output in the zero inflation case is only a little below that in the higher inflation. But for large shocks persisting a few quarters, differences in output paths across high- and low-inflation scenarios can be larger.

Without a doubt, these results are somewhat model-specific, and their real-world implications depend on how quickly a central bank can recognize shocks and how vigorously it can respond to them. Moreover, in situations when the zero bound on nominal interest rates does limit the ability of the central bank to stimulate the economy by reducing interest rates, other policy tools--such as fiscal policy may still be effective. Nonetheless, this research suggests that the constraint on monetary policy posed by the zero bound is an issue that merits careful thought and perhaps further investigation in alternative model settings.

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