The Routes into and out of the Zero Lower Bound

The United States and most other advanced countries are closing on five years of flat-out expansionary monetary policy that has failed in all cases to restore normal conditions of employment and output. These countries have been in liquidity traps, where monetary policies that normally expand the economy by enlarging the monetary base are ineffectual. Reserves have become near-perfect substitutes for government debt, so open-market policies of funding purchases of debt with reserves have essentially no effect. The U.S. economy entered this state because a financial crisis originating in a financial system built largely on real-estate claims came close to collapse when the underlying assets lost value. Rising risk premiums discouraged investments in plant, equipment, and new hiring. Weakened banks and declining collateral values depressed lending to households and forced their deleveraging. The combination of low investment and low consumption resulted in an extraordinary decline in output demand, which called for a markedly negative real interest rate, one unattainable because the zero lower bound on the nominal interest rate coupled with low inflation put a lower bound on the real rate at only a slightly negative level. As output demand recovers, the lower bound will cease to be an impediment and normal conditions will prevail again.