RDP 2005-04: Monetary Policy, Asset-Price Bubbles and the Zero Lower Bound Appendix A: Recent Literature
June 2005
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This paper lies at the intersection of two broad areas, both of which have been the subject of extensive research interest in recent years.
The first relates to the issue of how monetary policy should respond to asset-price bubbles. Work in this area has focused on whether policy-makers ought to make allowances for perceived asset-price misalignments in setting policy and, if so, whether such allowances ought to be explicit, through the inclusion of asset prices in either the policy-maker's objective function or policy rule, or merely implicit.[22] A related issue, which has also received recent attention, is whether success in achieving low and stable inflation may, in fact, increase either the frequency with which asset-price misalignments develop, or the severity of such misalignments (Borio and Lowe 2002).
The second broad research area relates to the implications, both for the economy and for monetary policy, of deflation and the ZLB on nominal interest rates. An initial wave of interest in these implications was prompted by Japan's experiences with both phenomena, starting around the late 1990s. More recently, such research gained renewed impetus from concerns for a time that some other major economies, such as the United States and Germany, might have been flirting with deflation following significant economic downturns.
Within this second broad area, the literature to date may be roughly divided into two streams. The first stream consists of theoretical analyses of the policy issues raised by deflation and the ZLB. These issues include the causes and implications of a liquidity trap, and the role (if any) of foreign exchange or asset-market interventions in escaping from such a trap (see, for example, Svensson 2001 and McCallum 2000). They also encompass the costs and benefits of co-ordinated fiscal and monetary policy actions, such as ‘helicopter drops’ (Bernanke 2000), or of other more abstract policy options such as Gesell taxes on money balances (Goodfriend 2000), designed to extricate an economy from deflation. Finally, they include the role (if any) of the choice of monetary policy regime – and in particular the decision whether or not to adopt a price-level or inflation target – in helping an economy to escape from deflation (Krugman 1998).
The second stream consists of empirical or historical examinations of these same issues. Such examinations have primarily focused on the experience of Japan since the early 1990s (see, for example, Posen 2003 and Fukao 2003), but also include re-examinations of other relevant episodes, such as the attempt by United States authorities in the 1960s to increase liquidity, and lower long-term bond rates, through ‘Operation Twist’ (see Modigliani and Sutch 1966).[23]
As noted earlier, this paper lies at the overlap between the two broad research areas just described. From this viewpoint, the asset-price bubbles in this paper may be regarded, at one level, as just one particular source of shocks with the potential to drive the economy to a state where the ZLB becomes a constraint on policy – especially if inflation is being held at too low a level prior to such a shock. The experiences of Japan in the early 1990s, and of the United States more recently, suggest that this is certainly an important area for research.
There is an important difference, however, between our focus in this paper and that of the bulk of the literature on deflation and the ZLB just described. The greater part of that literature concentrates on the economic implications of the ZLB, and on what policy-makers should do to escape from this constraint once it has been reached. By contrast, our concern in this paper is with the ways in which the existence of the ZLB ought to influence policy-makers prior to any negative shock – in our setting, caused by the collapse of a bubble – which might drive the economy into recession and deflation.