Yield Curve Control and Zero Interest Rate Policy in a Small Open Economy

Abstract

At the zero lower bound, the expected duration of zero interest rate policy has two dimensions which are key to understanding the stance of monetary policy: (i) the actual duration communicated by the central bank or expected by the private sector, and (ii) the duration prescribed by the underlying monetary policy rule—the rule that is in place in normal times. In a small open economy, the duration prescribed by the underlying monetary policy rule depends in part on foreign economic conditions. including foreign monetary policy. A monetary policy tightening abroad depreciates the exchange rate, increases inflation and shortens the duration prescribed by the monetary policy rule. We argue that a monetary policy strategy like yield curve control that aims to pin down a given duration is risky when economic shocks can change the duration prescribed by the underlying monetary policy rule.