THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 474

442

PA R T V

Central Banking and the Conduct of Monetary Policy

Dollar
goes
up

Increase in
target for the
overnight
interest rate

Decrease
in
demand

Prices

$

Costs
Ra
t

Interest
rates
go up

F I G U R E 17- 5

e

of

In
fla
tio
n

How the Bank of Canada Keeps the Rate of Inflation from Moving
Above the Target Range

Source: Bank of Canada website: www.bankofcanada.ca. Reprinted with permission.

This transmission mechanism works well even when the short-term nominal
interest rate is at or close to zero. With a nominal interest rate of zero, a commitment by the central bank to expansionary monetary policy raises the expected
inflation rate, ir * i + pe, reduces the real interest rate, pe, and leads to a rise in
aggregate output. Thus, expansionary monetary policy could stimulate spending
even when the short-term nominal interest rate is at zero. In fact, this mechanism
is the key element in monetarist discussions of why an expansionary monetary
policy could have prevented the sharp decline in output in the United States during the Great Depression, why it would have helped the Japanese economy when
nominal interest rates fell to near zero in the late 1990s, and why it could help
cope with the recent financial crisis and the global economic meltdown.
However, the collapse of stable relationships in financial markets may be causing the term structure of interest rate relationships on which the Keynesian transmission mechanism depends to loosen. For example, the U.S. Federal Reserve
raised the target federal funds rate in seventeen consecutive meetings from June
2004 to July 2006, from 1% to 5.25%, but long-term interest rates in the United
States and around the world declined for most of this period. It has been argued
that the reason long-term interest rates did not respond over this period of monetary tightening was the adoption of an inflation-targeting approach to monetary

policy by many countries and increased competition from China and India in
labour and product markets that contributed to price stability and put downward
pressure on long-term interest rates by reducing inflationary expectations.
Similarly, the recent decline in the federal funds rate to its current range of 0%
to 0.25% from 5.25% in August of 2007 has not led to the desired decline in long-