A major feature of recent monetary policy in Japan has been a heavy reliance on the so-called policy-duration effect. Even after short-term interest rates fall to virtually zero, a central bank can continue to ease monetary policy by committing to maintaining zero interest rates for a considerable period of time or to providing an ample monetary base to reduce short-term interest rates to zero. This paper analyzes the behavior of the yield curve and examines the effectiveness and limitations of monetary policy commitment under zero interest rates in the sample period we use (from March 1998 to February 2003). The policy-duration effect is found to be highly effective in stabilizing market expectations for the path of short-term interest rates, thereby reducing longer-term interest rates and flattening the yield curve; but it fails to reverse deflationary expectations in financial markets. Monetary policy alone is unable to reverse deflation, when coupled with low economic growth.
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