Keywords: Monetary policy, liquidity trap, Federal Reserve Act, open market operations, discount window lending
Abstract: In an environment of low inflation, the Federal Reserve faces the
risk that it has not provided enough monetary stimulus even when it has
pushed the short-term nominal interest rate to its lower bound of zero.
Assuming the nominal Treasury-bill rate has been lowered to zero, this
paper considers whether further open market purchases of Treasury bills
could spur aggregate demand through increases in the monetary base that
may stimulate aggregate demand by increasing liquidity for financial
intermediaries and households; by affecting expectations of the future
paths of short-term interest rates, inflation, and asset prices; or
by stimulating bank lending through the credit channel.
This paper also examines the alternative policy tools that are
available to the Federal Reserve in theory, and notes the practical
limitations imposed by the Federal Reserve Act, The tools the Federal
Reserve has at its disposal include open market purchases of Treasury
bonds and private-sector credit instruments (at least those that may be
purchased by the Federal Reserve); unsterilized and sterilized intervention
in foreign exchange; lending through the discount window; and, perhaps in
some circumstances, the use of options.
Full paper (379 KB PDF)
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Last update: November 30, 2000