Monetary Policy at the Zero Lower Bound

A central bank is confronting a severe economic downturn and has lowered its nominal policy interest rate to its absolute minimum of 0%. The bank's economists determine that a real interest rate of -1.5% is necessary to stimulate the economy. However, households and firms are currently expecting a deflation rate of 1% per year. Under these conditions, what will be the actual real interest rate, and what is the likely consequence for the economy?

The Role of Inflation Expectations at the Zero Lower Bound

Inflation Expectations and Real Interest Rates

A central bank has set its nominal policy interest rate to the zero lower bound (0%). Match each scenario of expected inflation with the correct resulting real interest rate.

Statement: If an economy is experiencing a severe downturn and the public widely expects prices to fall by 2% over the next year, a central bank can successfully encourage borrowing and investment by lowering its main policy interest rate to 0%.

To achieve a target real interest rate of -1.5% when the nominal policy rate is constrained at 0%, the central bank must ensure that the public's expected inflation rate is at least ____%.

An economy is facing a severe recession. Arrange the following events in the logical causal sequence that illustrates the challenge for monetary policy when its main interest rate is at its lowest possible level.

An economy is in a severe recession, and the central bank has lowered its nominal policy interest rate to 0%. Despite this, investment and consumption remain stagnant. A group of policy advisors argues that the central bank's most effective remaining tool is to publicly and credibly commit to achieving a higher rate of price increases in the future. What is the primary economic rationale behind this recommendation?

An economy is experiencing a severe and prolonged downturn. The central bank has already cut its main policy interest rate to 0%, but borrowing and spending have not recovered. Which of the following policy announcements from the central bank would be the most counterproductive to its goal of stimulating the economy?