Losing traction? The real effects of monetary policy when interest rates are low

Abstract

Are there limits to how far reductions in interest rates can boost aggregate demand?
In particular, as interest rates fall to very low levels, does the effectiveness of monetary
policy in boosting the economy wane? We provide evidence consistent with this
hypothesis. Based on a panel of 18 advanced countries starting in 1985, we find that
monetary transmission to economic activity is substantially weaker when interest
rates are low. The results hold even when controlling for potential confounding non-linearities associated with debt levels and the business cycle as well as for the trend
decline in equilibrium interest rates. We also find evidence that the effectiveness of
monetary policy wanes the longer interest rates stay low. These findings suggest that
the observed flattening of the Phillips curve has gone hand in hand with a
corresponding steepening of the IS curve. Monetary policy trade-offs may have
become more challenging.

Keywords: Monetary policy, low interest rates, monetary transmission mechanism

JEL Classification: E20, E52, E58