Zero lower bound and monetary policy models

Question 1

The MP curve

Answer 1

Question 2

AD curve equation 1

Answer 2

Question 3

AD curve equation 2

Answer 3

Question 4

IS curve

Answer 4

Question 5

What happens when the CB hits the zero lower bound

Answer 5

With the federal funds rate at the floor of zero:
* » CB cannot lower the real interest rate any further.
* » Occurred after the Lehman Brothers bankruptcy in late 2008 and during the Covid-19 crisis.
* » as inflation and expected inflation fall, the real interest rate rises, creating a downward slope for the MP curve.
* » The process described above also creates a kink in the AD curve as shown in Figure 10.
* » Conventional MP becomes ineffective.

Question 5

What happens when the CB hits the zero lower bound

Answer 5

With the federal funds rate at the floor of zero:
* » CB cannot lower the real interest rate any further.
* » Occurred after the Lehman Brothers bankruptcy in late 2008 and during the Covid-19 crisis.
* » as inflation and expected inflation fall, the real interest rate rises, creating a downward slope for the MP curve.
* » The process described above also creates a kink in the AD curve as shown in Figure 10.
* » Conventional MP becomes ineffective.

Question 6

Derivation of the AD curve with the ZLB

Answer 6

Question 7

Supply side curves

Answer 7

Question 8

Consequences of doing nothing when zero lower bound is reached

Answer 8

equilibrium output is below potential output

output is not restored to its potential level if policy makers do nothing

economy goes into a deflationary spiral

characterised by continuing falling inflation and output

• When output is below potential, inflation falls, interest rates rise, investment falls, so output falls

this continues

Question 9

the disappearance of the self-correcting mechanism at the zero lower bound

Answer 9

Question 10

Non-conventional monetary policy at the ZLB

Answer 10

1. Liquidity provision
2. LSAP
3. Forward guidance and management of expectations

These help to raise aggregate output and inflation by reducing the real interest rate for investments

Question 11

Liquidity provision at the ZLB

Answer 11

At the ZLB credit markets seize up and there is shortage of liquidity. Shortage of liquidity results in the rise of financial frictions. Economy moves to point 1 as shown by Figure 12.
A CB can lower f ̄ directly by increasing its lending facilities. » This provides more liquidity to impaired markets.
» So that they can return to their normal functions.
» The decline in financial frictions lowers the real interest rate for investments.

Question 12

Asset purchases and quantitive easing

Answer 12

In this case CBs lower financial frictions by lowering credit spreads through the purchase of private assets.
Though the Fed took action,
* » the negative aggregate demand shock to the economy from the global financial crisis was so great.
* » the Fed’s quantitative (credit) easing was insufficient to overcome it.
* » Fed was unable to shift the AD curve all the way back to equilibrium.
* » The economy still suffered a severe recession.