University College Dublin, MA Macroeconomics Notes, 2014 (Karl Whelan) Page 1

The Zero Lower Bound and the Liquidity Trap

Up to now, we have assumed that the central bank in our model economy sets its interest rate

according to a specific policy rule. Whatever the rule says the interest rate should be, the

central banks sets that interest rate. But what if the rule predicts the central bank should set

interest rates equal to a negative value? Will they?

Well let’s step back a minute and think about what the interest rate it in our model

actually means. This interest rate appears in the IS curve because we think higher real

interest rates discourage consumption and investment spending by the private sector. So

the relevant interest rates here are interest rates that private sector agents borrow at. And

indeed, if you look at the interest rates that central banks target, they are generally short-term

“money market” interest rates on transactions featuring private sector agents on both sides of

the deal. For example, the Federal Reserve targets the federal funds rate, which is the rate at

which banks borrow and lend short-term funds to and from each other. The ECB also targets

money market rates in the Euribor market.

With this in mind, consider why these private sector interest rates are unlikely to ever

be negative. If I loan you $100 and only get $101 back next period, I haven’t earned much

interest but at least I earned some. A negative interest rate would mean me loaning you $100

and getting back less than that next year. Why would I do that? Since money maintains its

nominal face value, I’d be better off just the keep the money in my bank account or under a

mattress.

With this in mind, we are going to adapt our model to take into account that there are

times when the central bank would like to set it below zero but is not able to do so.
University College Dublin, MA Macroeconomics Notes, 2014 (Karl Whelan) Page 2

The Zero Lower Bound

When will the “zero lower bound” become a problem for a central bank? In our IS-MP-

PC model, it depends on the form of the monetary policy rule. Up to now, we have been

considering a monetary policy rule of the form

it = r∗ + π ∗ + βπ (πt − π ∗ ) (1)

This rule sees the nominal interest rate adjusted upwards and downwards as inflation changes.

So the lower bound problem occurs when inflation goes below some critical value. This

value might be negative, so it may occur when there is deflation, meaning prices are falling.

Amending our model to remove the possibility that interest rates could become negative, our

new monetary policy rule is

it = Maximum [r∗ + π ∗ + βπ (πt − π ∗ ) , 0] (2)

Because the intended interest rate of the central bank declines with inflation, this means that

there is a particular inflation rate, π ZLB , such that if πt < π ZLB then the interest rate will

equal zero. So what determines this specific value, π ZLB that triggers the zero lower bound?

Algebraically, we can characterise π ZLB as satisfying

 
r∗ + π ∗ + βπ π ZLB − π ∗ = 0 (3)

This can be re-arranged as

βπ π ZLB = βπ π ∗ − r∗ − π ∗ (4)

which can be solved to give

r∗
!
βπ − 1
π ZLB
= π∗ − (5)
βπ βπ
University College Dublin, MA Macroeconomics Notes, 2014 (Karl Whelan) Page 3

Equation (5) tells us that three factors determine the value of inflation at which the central

bank sets interest rates equal to zero.

1. The inflation target: The higher the inflation target π ∗ is, then the higher is the level

of inflation at which a central bank will be willing to set interest rates equal to zero.

2. The natural rate of interest: A higher value of r∗ , the “natural” real interest rate,

lowers the level of inflation at which a central bank will be willing to set interest rates

equal to zero. An increase in this rate makes central bank raise interest rates and so

they will wait until inflation goes lower than previously to set interest rates to zero.

3. The responsiveness of monetary policy to inflation: Increases in βπ raise the

coefficient on π ∗ in this formula, increasing the first term and it makes the second term

(which has a negative sign) smaller. Both effects mean a higher βπ translates into a

higher value for π ZLB . Central banks that react more aggressively against inflation will

wait for inflation to reach lower values before they are willing to set interest rates to

zero.

The IS-MP Curve and the Zero Lower Bound

Given this characterisation of when the zero lower bound kicks in, we need to re-formulate the

IS-MP curve. Once inflation falls below π ZLB , the central bank cannot keep cutting interest

rates in line with its monetary policy rule. Recalling that the IS curve

yt = yt∗ − α (it − πt − r∗ ) + yt (6)

We had previously derived the IS-MP curve by substituting in the monetary policy rule
University College Dublin, MA Macroeconomics Notes, 2014 (Karl Whelan) Page 4

formula (1) for it term. This gave us the IS-MP curve as:

yt = yt∗ − α (βπ − 1) (πt − π ∗ ) + yt (7)

However, when πt ≤ π ZLB we need to substitute in zero instead of the negative value that the

monetary policy rule would predict. So the IS-MP curve becomes


yt∗ − α (βπ − 1) (πt − π ∗ ) + yt when πt > π ZLB



yt =  (8)
  yt∗ + αr∗ + απt + yt when πt ≤ π ZLB

The effect of inflation on output in this revised IS-MP curve changes when inflation moves

below π ZLB . Above π ZLB , higher values of inflation are associated with lower values of output.

Below π ZLB , higher values of inflation are associated with higher values of output. Graphically,

this means the IS-MP curve shifts from being downward-sloping to being upward-sloping when

inflation falls below π ZLB . Figure 1 provides an example of how this looks.

Equation (8) also explains the conditions under which the zero lower bound is likely to

be relevant. If there are no aggregate demand shocks, so yt = 0, then the zero lower bound

is likely to kick in at a point where output is above its natural rate; see Figure 1 for an

illustration of this case. But this combination of high output and low inflation is unlikely to

be an equilibrium in the model unless the public expects very low inflation or deflation so the

Phillips curve intersects the IS-MP curve along the section that has output above its natural

rate and inflation below π ZLB .

However, if we have a large negative aggregate demand shock, so that yt < 0, then it is

possible to have output below its natural rate and inflation falling below π ZLB . As illustrated

in Figure 2, this situation is more likely to be an equilibrium (i.e. this position for the IS-MP

curve is more likely to intersect with the Phillips curve) even if inflation expectations are close

to the inflation target.

University College Dublin, MA Macroeconomics Notes, 2014 (Karl Whelan) Page 5

Figure 1: The IS-MP Curve with the Zero Lower Bound

IS-MP ( =0)

Inflation

Output
University College Dublin, MA Macroeconomics Notes, 2014 (Karl Whelan) Page 6

Figure 2: A Negative Aggregate Demand Shock

IS-MP ( =0)

Inflation
PC ( )
IS-MP ( < 0)

Output
University College Dublin, MA Macroeconomics Notes, 2014 (Karl Whelan) Page 7

The Liquidity Trap

When inflation falls below the lower bound, output is determined by

yt = yt∗ + αr∗ + απt + yt (9)

Inflation is still determined by the Phillips curve

πt = πte + γ (yt − yt∗ ) + πt (10)

Using the expression for the output gap when the zero lower bound limit has been reached

from equation (9) we get an expression for inflation under these conditions as follows

πt = πte + γ (αr∗ + απt + yt ) + πt (11)

This can be re-arranged to give

1 αγ ∗ γ 1
πt = πte + r + yt + πt (12)
1 − αγ 1 − αγ 1 − αγ 1 − αγ

1
The coefficient on expected inflation, 1−αγ
is greater than one. So, just as with the Taylor

principle example from the last notes, changes in expected inflation translate into even bigger

changes in actual inflation. As we discussed the last time, this leads to unstable dynamics.

Because these dynamics take place only when inflation has fallen below the zero lower bound,

the instability here relates to falling inflation expectations, leading to further declines in

inflation and further declines in inflation expectations. Because output depends positively

on inflation when the zero-bound constraint binds, these dynamics mean falling inflation (or

increasing deflation) and falling output.

This position in which nominal interest rates are zero and the economy falls into a defla-

tionary spiral is known as the liquidity trap. Figures 3 and 4 illustrate how the liquidity trap
University College Dublin, MA Macroeconomics Notes, 2014 (Karl Whelan) Page 8

operates in our model. Figure 3 shows how a large negative aggregate demand shock can lead

to interest rates hitting the zero bound even when expected inflation is positive.

Figure 4 illustrates how expected inflation has a completely different effect when the zero

lower bound has been hit. It shows a fall in expected inflation after the negative demand shock

(this example isn’t adaptive expectations because I haven’t drawn inflation expectations falling

all the way to the deflationary outcome graphed in Figure 3). In our usual model set-up, a

fall in expected inflation raises output. However, once at the zero bound, a fall in expected

inflation reduces output, which further reduces inflation.

University College Dublin, MA Macroeconomics Notes, 2014 (Karl Whelan) Page 9

Figure 3: Equilibrium At the Lower Bound

IS-MP ( =0)

Inflation
PC ( )
IS-MP ( < 0)

Output
University College Dublin, MA Macroeconomics Notes, 2014 (Karl Whelan) Page 10

Figure 4: Falling Expected Inflation Worsens Slump

IS-MP ( =0)

Inflation
PC ( )
IS-MP ( < 0)

PC ( )

Output
University College Dublin, MA Macroeconomics Notes, 2014 (Karl Whelan) Page 11

The Liquidity Trap with a Taylor Rule

For the simple monetary policy rule that we have been using, the zero lower bound is hit for

a particular trigger level of inflation. Plugging in reasonable parameter values into equation

(5) this trigger value will most likely be negative. In other words, with the monetary policy

rule that we have been using, the zero lower bound will only be hit when there is deflation.

However, if we have a different monetary policy rule this result can be overturned. For

example, remember the Taylor-type rule we considered in the first set of notes

it = r∗ + π ∗ + βπ (πt − π ∗ ) + βy (yt − yt∗ ) (13)

Incorporating the zero lower bound, this would be adapted to be

it = Maximum [r∗ + π ∗ + βπ (πt − π ∗ ) + βy (yt − yt∗ ) , 0] (14)

For this rule, the zero lower bound is hit when

r∗ + π ∗ + βπ (πt − π ∗ ) + βy (yt − yt∗ ) = 0 (15)

This condition can be re-written as

βπ (πt − π ∗ ) + βy (yt − yt∗ ) = −r∗ − π ∗ (16)

In other words, there are a series of different combinations of inflation gaps and output gaps

that can lead to monetary policy hitting the zero lower bound. For example, if yt = yt∗ the

lower bound will be hit at the value of inflation given by equation (5), i.e. the level we have

defined as π ZLB . In contrast, inflation could equal its target level but policy would hit the
r∗ +π ∗
zero bound if output fell as low as yt∗ − βy
.

Graphically, we can represent all the combinations of output and inflation that produce

zero interest rates under the Taylor rule as the area under a downward-sloping line in Inflation-

Output space. Figure 5 gives an illustration of what this area would look like. We showed
University College Dublin, MA Macroeconomics Notes, 2014 (Karl Whelan) Page 12

in the first set of notes that when we are above the zero bound, the IS-MP curve under the

Taylor rule is of the same downward-sloping form as under our simple inflation targeting rule.

At the zero bound, the arguments we’ve already presented here also apply so that the IS-MP

curve becomes upward sloping.

Figure 6 illustrates two different cases of IS-MP curves when monetary policy follows a

Taylor rule. The right-hand curve corresponds to the case yt = 0 (no aggregate demand

shocks) and this curve only interests with the zero bound area when there is a substantial

deflation. In contrast, the left-hand curve corresponds to the case in which yt is highly negative

(a large negative aggregate demand shocks) and this curve interests with the zero bound area

even at levels of inflation that are positive and aren’t much below the central bank’s target.
University College Dublin, MA Macroeconomics Notes, 2014 (Karl Whelan) Page 13

Figure 5: Zero Bound is Binding in Blue Triangle Area

Inflation

Output
Zero Lower
Bound Area
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Figure 6: Zero Bound Can Be Hit With Positive Inflation

IS-MP ( =0)

Inflation IS-MP ( < 0)

Output
University College Dublin, MA Macroeconomics Notes, 2014 (Karl Whelan) Page 15

The Liquidity Trap: Reversing Conventional Wisdom

An important aspect of this model of the liquidity trap is it shows that some of the predictions

that our model made (and which are now part of the conventional wisdom among monetary

policy makers) do not hold when the economy is in a liquidity trap.

Up to now we have seen that as long as the central bank maintains its inflation targets,

then the model with adaptive expectations predicts that deviations of the public’s inflation

expectations from this target will be temporary and the economy will tend to converge back

towards its natural level of output. However, once interest rates have hit the zero bound,

this is no longer the case. Instead, the adaptive expectations model predicts the economy can

spiral into an ever-declining slump.

Similarly, our earlier model predicted that a strong belief from the public that the central

bank would keep inflation at target was helpful in stabilising the economy. However, once

you reach the zero bound, convincing the public to raise its inflation expectations (perhaps

by announcing a higher target for inflation) is helpful.

How to Get Out of the Liquidity Trap?

The most obvious way that a liquidity trap can end is if there is a positive aggregate demand

shock that shifts the IS-MP curve back upwards so that the intersection with the Phillips

curve occurs at levels of output and inflation that gets the economy out of the liquidity trap.

However, in reality, liquidity traps have often occurred during periods when there are

ongoing and persistent slumps in aggregate demand. For example, after decades of strong

growth, the Japanese economy went into a slump during the 1990s. Housing prices crashed

and businesses and households were hit with serious negative equity problems. This type of
University College Dublin, MA Macroeconomics Notes, 2014 (Karl Whelan) Page 16

“balance sheet” recession doesn’t necessarily reverse itself quickly. The result in Japan has

been a persistent deflation since the mid-1990s (see Figure 7) combined with a weak economy.

The Bank of Japan has set short-term interest rates close to zero throughout this period (see

Figure 8).

Given that economies in liquidity traps tend not to self correct with positive aggregate

demand shocks from the private sector, governments can try to boost the economy by us-

ing fiscal policy to stimulate aggregate demand. Japan has used fiscal stimulus on various

occasions with limited success.

What about monetary policy? With its policy interest rates at zero, can a central bank

do any more to boost the economy? Debates on this topic have focused on two areas.

The first area relates to the fact that while the short-term interest rates that are controlled

by central banks may be zero, that doesn’t mean the longer-term rates that many people

borrow at will equal zero. By signalling that they intend to keep short-term rates low for a

long period of time and perhaps by directly intervening in the bond market (i.e. quantitative

easing) central banks can attempt to lower these longer-term rates.

The second area relates to inflation expectations. Our model tells us that output can be

boosted when the economy is in a liquidity trap by raising inflation expectations. This acts

to raise inflation (or reduce deflation) and this reduces real interest rates and boost output.

As an academic and during his early years as a member of the Federal Reserve Board of

Governors (prior to becoming Chairman) Ben Bernanke advocated that the Bank of Japan

should attempt to raise inflation expectations by committing to having a period of inflation

above their target level of 1%. In a 2003 speech titled “Some Thoughts on Monetary Policy

in Japan” Bernanke said:

University College Dublin, MA Macroeconomics Notes, 2014 (Karl Whelan) Page 17

What I have in mind is that the Bank of Japan would announce its intention to

restore the price level (as measured by some standard index of prices, such as the

consumer price index excluding fresh food) to the value it would have reached if,

instead of the deflation of the past five years, a moderate inflation of, say, 1 percent

per year had occurred.

The Bank of Japan did not take Bernanke’s advice. More recently, however, under pressure

from the new Japanese government, the Bank of Japan have changed their inflation target from

1% per year to 2% per year. Though not as radical as the steps recommended by Bernanke

and others, it is clear that the current Japanese authorities recognise the importance of raising

inflation expectations.

A third area relates to exchange rates. To raise inflation, a central bank could announce

targets for its exchange rate that would see it fall in value relative to the its major trading

partners. Such a programme could be implemented by the central bank announcing that it

is willing to buy and sell unlimited amounts of foreign exchange at an announced exchange

rate e.g. The ECB could announce that it is willing to swap a euro for $1. Even though the

market rate may have been higher than this, nobody will now pay more for a euro than the

rate available from the ECB. This currency depreciation would make imports more expensive,

which would raise inflation. This latter approach has been labelled the “foolproof way to

escape from a liquidity trap” by leading monetary policy expert Lars Svensson.1

1
Lars Svensson (2003). “Escaping from a Liquidity Trap and Deflation: The Foolproof Way and Others.”

Journal of Economic Perspectives.

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Figure 7: Consumer Price Index in Japan

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Figure 8: Short-Term Interest Rates in Japan

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Are the US and Euro Area in Liquidity Traps?

In recent years, the US economy has been in a position that, in some ways, resembles the

position of the Japanese economy during its long liquidity trap period. The economic recov-

ery that started in 2009 has been very weak by historical standards and unemployment has

remained fairly high. In response to this weakness, the Federal Reserve has kept its policy

rate (the federal funds rate) at close to zero since late 2008.

Has the US been in a liquidity trap and should the Fed have been considering more radical

policies such as signalling its intent to allow a temporary rise in inflation? Once Ben Bernanke

became Chairman of the Fed, he was not as keen to implement the ideas he recommended as

an academic. One argument that Bernanke advanced against providing price level guidance

was that the US was not in a liquidity trap because inflation is still positive. However, as

we’ve seen above, for a central bank that responds to deviations of output from its natural

rate (and clearly the Fed does this) then you can have liquidity-trap conditions even with

positive inflation. The key feature of the liquidity trap is zero short-term rates, not deflation.

And this feature has held in the U.S. for a number of years.

Why did Bernanke not adopt the policy he had recommended to the Japanese? The

explanation seems to be that he was concerned that non-standard policies will undermine the

Fed’s longer-term credibility. At his April 2012 press conference, he said:

I guess the question is, does it make sense to actively seek a higher inflation rate

in order to achieve a slightly increased reduction—a slightly increased pace of

reduction in the unemployment rate? The view of the Committee is that that

would be very reckless. We have—we, the Federal Reserve—have spent 30 years

building up credibility for low and stable inflation, which has proved extremely
University College Dublin, MA Macroeconomics Notes, 2014 (Karl Whelan) Page 21

valuable in that we’ve been be able to take strong accommodative actions in the

last four or five years to support the economy without leading to an unanchoring

of inflation expectations or a destabilization of inflation. To risk that asset for

what I think would be quite tentative and perhaps doubtful gains on the real side

would be, I think, an unwise thing to do.

This suggests that Chairman Bernanke was still more focused on the benefits of well-anchored

low inflation expectations during normal times than on the potential benefits of non-standard

policies in getting the economy out of a slump.

Nobel prize winner Paul Krugman, Bernanke’s former colleague at Princeton, was critical

of Bernanke’s unwillingness to attempt to raise inflationary expectations. See the link on

the website to Krugman’s article recommending that “Chairman Bernanke should listen to

Academic Bernanke”. From his research on Japan in the late 1990s, Krugman has discussed

the tension that central bankers feel when in a liquidity trap. When up against the zero

bound, they might like to raise inflation expectations but then they are concerned that this

could make inflation go higher than they would like. The public’s awareness that the central

bank will clamp down on inflation if the economy picks up then prevents there being a sufficient

increase in inflation rates to get the economy out of the liquidity trap. Krugman thus stresses

the need for central banks facing a liquidity trap to “‘commit to being irresponsible” as

a way out of these slumps—commit to a temporary period of inflation being higher than

you would normally like. But central bankers are a conservative crowd and even temporary

“irresponsibility” does not come easy to them.

The Fed has adopted a number of new policies in recent years such as quantitative easing

and “enhanced forward guidance” in which they signal that rates will stay low for a long
University College Dublin, MA Macroeconomics Notes, 2014 (Karl Whelan) Page 22

period. More recently, they have discussed conditions under which they will reduce their QE

purchases and outlined the conditions under which they will keep rates at zero. So there

are signs that the Fed is willing to be flexible. Time will tell if the debate about price-

level targeting or raising the target inflation rate produces a change in policy at the Fed.

With many unconventional tools having been introduced over the past few years, it will be

interesting to see if any of the leading central banks will consider moving away from narrow

inflation targeting regimes.

Short-term interest in the euro area are also essentially equal to zero. While Mario Draghi

argues there is no cause for concern because there is no deflation as of yet, inflation is extremely

low and the ECB has effectively run out of room for influencing the economy through the

regular interest rate channel. So the euro area also appears to be resemble the liquidity trap

situation we have described here. Given the ECB’s legal requirement to place price stability

above all other goals, they seem unlikely to adopt the kind of policies that can take an economy

out of a liquidity trap.

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Figure 9: The Fed Has Been at the Lower Bound Since 2008
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Figure 10: The ECB Has Also Hit the Lower Bound
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Things to Understand from these Notes

Here’s a brief summary of the things that you need to understand from these notes.

1. Why there is a zero bound on interest rates.

2. The factors that influence when the central bank sets zero rates.

3. How the IS-MP curve changes when incorporating the zero lower bound.

4. How changes in inflation expectations affect the economy above and below the zero lower

bound.

5. What is meant by the liquidity trap, i.e. why the economy doesn’t automatically recover

when the zero bound binds.

6. How the IS-MP-PC graphs work when we incorporate the zero bound.

7. Policies to get out of the liquidity trap.

8. Bernanke’s advice to the Bank of Japan and change of mind as Fed Chairman.

9. Why the US and Euro Area economies could be considered to be in a liquidity trap.

10. The debate about “committing to be irresponsible.”