Monetary and Economic Studies Vol.24, No.S-1 / December 2006

Misconceptions Regarding the Zero Lower Bound on Interest Rates

Bennett T. McCallum

The paper reviews issues related to the zero lower bound (ZLB) on interest rates and argues that all of the following propositions are invalid: (1) in a ZLB situation, "shaping interest rate expectations is essentially the only tool that central bankers have" (Bernanke, Reinhart, and Sack [2004]); (2) fiscal policy actions such as "helicopter drops" are in theory more effective than monetary policy actions; (3) the prominent "foolproof way" policy rule of Svensson (2001, 2003) is applicable more generally-that is, even when exact uncovered interest parity holds-than the alternative exchange rate rule of McCallum (2000); (4) both of the exchange rate strategies described in (3) are open to the objection that they constitute "beggar-thy-neighbor" approaches; and (5) there is a significant danger of ZLB difficulties stemming from a "deflationary trap" type of equilibrium, as distinct from a "liquidity trap."

Keywords: Interest rates; Zero lower bound; Quantitative easing; Expectations; Deflation trap; Liquidity trap

Views expressed in the paper are those of the authors and do not necessarily reflect those of the Bank of Japan or Institute for Monetary and Economic Studies.

Copyright © 2006 Bank of Japan All Rights Reserved.

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