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In this paper we study the role of the exchange rate in conducting monetary policy in an economy with near-zero nominal interest rates as experienced in Japan since the mid-1990s. Our analysis is based on an estimated model of Japan, the United States and the euro area with rational expectations and nominal rigidities. First, we provide a quantitative analysis of the impact of the zero bound on the effectiveness of interest rate policy in Japan in terms of stabilizing output and inflation. Then we evaluate three concrete proposals that focus on depreciation of the currency as a way to ameliorate the effect of the zero bound and evade a potential liquidity trap. Finally, we investigate the international consequences of these proposals.

Having achieved consistently low inflation rates monetary policymakers in industrialized countries are now confronted with a new challenge—namely how to prevent or escape deflation. Deflationary episodes present a particular problem for monetary policy because the usefulness of its principal instrument, that is the short-term nominal interest rate, may be limited by the zero lower bound. Nominal interest rates on deposits cannot fall substantially below zero, as long as interest-free currency constitutes an alternative store of value.1 Thus, with interest rates near zero policymakers will not be able to stave off recessionary shocks by lowering nominal and thereby real interest rates. Even worse, with nominal interest rates constrained at zero deflationary shocks may raise real interest rates and induce or deepen a recession. This challenge for monetary policy has become most apparent in Japan with the advent of recession, zero interest rates and deflation in the second half of the 1990s.2 In response to this challenge, researchers, practitioners and policymakers alike have presented alternative proposals for avoiding or if necessary escaping deflation.3 In this paper, we provide a quantitative evaluation of the importance of the zero-interest-rate bound and the likelihood of a liquidity trap in Japan. Then, we proceed to investigate three recent proposals on how to stimulate and re-inflate the Japanese economy by exploiting the exchange rate channel of monetary policy. These three proposals, which are based on studies by McCallum 2000 and McCallum 2001, Orphanides and Wieland (2000) and Svensson (2001), all present concrete strategies for evading the liquidity trap via depreciation of the Japanese Yen. Our quantitative analysis is based on an estimated macroeconomic model with rational expectations and nominal rigidities that covers the three largest economies, the United States, the euro area and Japan. We recognize the zero-interest-rate bound explicitly in the analysis and use numerical methods for solving nonlinear rational expectations models.4 First, we consider a benchmark scenario of a severe recession and deflation. Then, we assess the importance of the zero bound by computing the stationary distributions of key macroeconomic variables under alternative policy regimes.5 Finally, we proceed to investigate the role of the exchange rate for monetary policy as proposed by Orphanides and Wieland (2000), McCallum 2000 and McCallum 2001 and Svensson (2001). Orphanides and Wieland (2000) (OW) emphasize that base money may have some direct effect on aggregate demand and inflation even when the nominal interest rate is constrained at zero. In particular they focus on the portfolio-balance effect, which implies that the exchange rate will respond to changes in the relative domestic and foreign money supplies even when interest rates remain constant at zero. As a result, persistent deviations from uncovered interest parity are possible. Of course, this effect is likely small enough to be irrelevant under normal circumstances, i.e. when nominal interest rates are greater than zero, and estimated rather imprecisely when data from such circumstances is used. OW discuss the policy stance in terms of base money and derive the optimal policy in the presence of a small and highly uncertain portfolio-balance effect. They show that the optimal policy under uncertainty implies a drastic expansion of base money with a resulting depreciation of the currency whenever the zero bound is effective. McCallum 2000 and McCallum 2001 (MC) also advocates a depreciation of the currency to evade the liquidity trap. In fact, he recommends switching to a policy rule that responds to output and inflation deviations similar to a Taylor-style interest rate rule, but instead considers the change in the nominal exchange rate as the relevant policy instrument. Svensson (2001) (SV) recommends a devaluation and temporary exchange-rate peg in combination with a price-level target path that implies a positive rate of inflation. Its goal would be to raise inflationary expectations and jump-start the economy. SV emphasizes that the existence of a portfolio-balance effect is not a necessary ingredient for such a strategy. By standing ready to sell Yen and buy foreign exchange at the pegged exchange rate, the central bank will be able to enforce the devaluation. Once the peg is credible, exchange rate expectations will adjust accordingly and the nominal interest rate will rise to the level required by uncovered interest parity. These authors presented their proposals in stylized, small open economy models. In this paper, we evaluate these proposals in an estimated macroeconomic model, which also takes into account the international repercussions that result when a large open economy such as Japan adopts a strategy based on drastic depreciation of its currency. In addition, we improve upon the following shortcomings. While OW used a reduced-form relationship between the real exchange rate, interest rates and base money, we treat uncovered interest parity and potential deviations from it explicitly in the model. While MC compares interest rate and exchange rate rules within linear models we account for the nonlinearity due to the zero bound when switching from one to the other and retain uncovered interest parity in both cases. Finally, we investigate the consequences of all three proposed strategies for the United States and the euro area. Our findings indicate that the zero bound induces noticeable losses in terms of output and inflation stabilization in Japan, if the equilibrium nominal interest rate, that is the sum of the policymaker's inflation target and the equilibrium real interest rate, is 2% or lower. We show that aggressive liquidity expansions when interest rates are constrained at zero, may largely offset the effect of the zero bound. Furthermore, we illustrate the potential of the three proposed strategies to evade a liquidity trap during a severe recession and deflation. Finally, we show that the proposed strategies have non-negligible beggar-thy-neighbor effects and may require the tacit approval of the main trading partners for their success. The paper proceeds as follows. Section 2 reviews the estimated three-country macro model. In Section 3 we discuss the consequences of the zero-interest-rate bound, first in case of a severe recession and deflation scenario, and then on average given the distribution of historical shocks as identified by the estimation of our model. In Section 4 we explore the performance of the three different proposals for avoiding or escaping the liquidity trap by means of exchange rate depreciation. Section 5 concludes.

Based on an estimated macroeconomic model of Japan, the United States and the euro area, we have been able to quantify the effect of the zero bound on stabilization performance in Japan. Furthermore, we have evaluated three concrete proposals for avoiding or evading the impact of the zero-interest-rate bound by depreciating the Yen with regard to the euro and the U.S. Dollar. Finally, we have quantified the resulting spillover effects to the United States and the euro area. We have focused our analysis on the case where all three central banks follow Taylor's (1993b) nominal interest rate rule. Our findings indicate that the zero bound should be expected to induce noticeable losses in terms of output and inflation stabilization in Japan once the nominal equilibrium interest rate, that is the sum of the policymaker's inflation target and the real equilibrium interest rate, is set at 2% or lower. On average, these losses are not very large but they may turn out to be quite substantial in the event of repeated adverse demand and price shocks. However, we note that our analysis abstracts from some important factors that have played a role in the 1990s in Japan. In particular, our model cannot capture the miserable state of Japan's banking sector, which is often cited as a major factor concerning the disappointing growth performance of the Japanese economy in the latter half of the 1990s. Rather, we evaluate the potential of monetary policy to improve Japan's economic performance under zero interest rates. We have included a small direct effect of base money on the exchange rate in our model. Due to this portfolio-balance effect monetary policy remains effective even when nominal interest rates are constrained at zero, however this effect is so small that it is usually not noticeable. As proposed by Orphanides and Wieland (2000), we have shown that aggressive liquidity expansions when interest rates are constrained at zero may largely offset the effect of the zero bound. Furthermore, we have illustrated the potential of the proposals by McCallum 2000 and McCallum 2001 and Svensson (2001) to evade a liquidity trap during a severe recession and deflation by setting a state-dependent or exogenous path for the nominal exchange rate. Our findings indicate that the proposed strategies have non-negligible beggar-thy-neighbor effects and may require the tacit approval of the main trading partners for their success. The implied decline in output in the United States appears smallest when we implement Svensson's proposal for a devaluation of the Yen. Sensitivity studies indicate that the negative spillover effects are smaller when nominal interest rates in the U.S. and in the euro area are set according to estimated policy rules or when the Taylor rule is augmented by a policy response to the exchange rate. Our analysis of spillover effects of a Yen devaluation is limited by the fact that Japan's major Asian trading partners are not included in our model. Thus, an interesting project for future research would be to assess the performance of the alternative depreciation-based proposals in a multi-country model that also accounts for the large share of Japan's trade with Asian countries.