The 1990s were not a pleasant time in Japan. After decades of rapid growth, the Japanese economy ground to a halt. Panel A of Figure 23.1 (38.0K) shows how poor Japan's economic performance was from 1993 to 2004. Over this 10-year period, Japanese growth averaged less than 1 percent per year—far below its average of nearly 4 percent in the 1980s. Japanese policymakers took action, lowering interest rates throughout the decade. Panel B of Figure 23.1 (38.0K) shows the downward path of the overnight cash rate, the Bank of Japan's policy instrument. Finally, in the winter of 1999, the Bank's policy board lowered the target interest rate to zero. Still, growth didn't pick up. With the interest rate at zero, there didn't appear to be much more the Bank of Japan could do. Nominal interest rates can't fall below zero.

Japan's experience in the 1990s contrasted sharply with that of the United States. While Japan's economy was floundering, the U.S. economy was booming: growth averaged nearly 4 percent per year from 1995 to 2000 (see Panel A of Figure 23.2 (38.0K) ). During this period, the Fed eased policy several times, and growth appeared to respond. As Panel B of Figure 23.2 (38.0K) shows, the FOMC lowered the targeted federal funds rate in the fall of 1998, in response to world financial crises,¹ and then raised it two years later in an effort to keep inflation from rising. When the economy finally did slow in 2001, the FOMC reduced the interest rate. The result was a quick recovery: in less than a year, the recession was over. Still, disappointed with the level of growth, the FOMC continued to ease rates until on June 25, 2003, the target federal funds rate hit 1 percent. At that point, people began to voice concern that U.S. policymakers might be traveling down the same road as the Bank of Japan. Were they?

The aggregate demand/aggregate supply framework described in Chapters 21 and 22 helps us to understand the sources of inflation and fluctuations in the business cycle, as well as how stabilization policy works. But it cannot explain what happened in Japan in the 1990s, nor did it provide any guide for the FOMC when the federal funds rate dropped near zero. To understand these cases, we must return to the question of how monetary policy affects the economy.

We know from Chapter 17 that policymakers' ability to influence the economy comes from their control over the size of the central bank's balance sheet. And we know from Chapter 18 that they can use their power over the balance sheet to control the interest rate banks charge each other for overnight loans. Because inflation is persistent, changing only slowly, policymakers can use this tool to influence the short-run real interest rate. In Chapter 21, we saw that the components of aggregate expenditure are sensitive to the real interest rate, so by changing the real interest rate, policymakers can influence real economic activity. Yet the Japanese experience suggests that this standard policy tool doesn't always work. To see why, we need to look at all the ways monetary policy actions can affect economic activity. That means recalling the role of financial intermediaries in solving the information problems that keep lenders and savers apart.

The purpose of this chapter is twofold. First, we will examine all the ways that monetary policy affects real economic activity—that is, all the channels through which monetary policy is transmitted. Second, we will look at the challenges central bankers face today. What are the factors that make modern monetary policy so difficult?

¹The crises of 1997 and 1998 have been mentioned at various points in this book. They first began in the summer of 1997 with problems in Thailand (described in Chapters 17 and 19) and Indonesia, then spread to Korea by the end of the year (see Chapter 10). In 1998, the Fed reduced the interest rate in response to problems caused by the Russian government's bond default (discussed in Chapter 6) and the collapse of Long- Term Capital Management (examined in Chapter 9).

FIGURE 23.1 SOURCE: Bank of Japan.

FIGURE 23.2 SOURCE: U.S. GDP data are from the Bureau of Economic Analysis, and federal funds data are from the Federal Reserve.