Monetary Policy under Low Interest Rates: The Experience of Switzerland in the late 1970s

In the 1990s, most industrialized and many other countries managed to restore price stability after a prolonged period of high inflation. Although a stable price level tends to enhance economic welfare, some economists (e.g., Summers, 1991) have questioned the wisdom of reducing inflation to very low levels. They argue that low rates of inflation may undermine a central bank’s ability to counteract adverse shocks to aggregate demand. Such shocks call for a reduction in real interest rates. In the presence of low inflation, nominal interest rates are likely to be low too. Since nominal interest rates normally do not assume negative values, the economy faces a liquidity trap at zero interest rates.1 Thus, the central bank may be powerless to react to adverse aggregate demand shocks by loosening monetary policy if nominal interest rates are already at low levels. The current woes of the Japanese economy are often cited as an illustration of the difficulties arising from adverse aggregate demand shocks in an environment of low nominal interest rates. Japan has passed through a long period of stagnation characterized by a stable or even declining price level and short-term nominal interest rates near zero. Numerous analysts have argued that the Bank of Japan’s inability to push real interest rates below zero is an important factor impeding the It is frequently argued that nominal interest rates cannot turn negative. This argument rests on the belief that negative nominal interest rates would prompt investors to substitute currency for interest-bearing assets. Thus, the demand for currency would become perfectly elastic at zero nominal interest rates. However, in the presence of transaction costs (e.g. through losses from robberies, etc.), investors might be prepared to hold cash even at negative interest rates. I