The problem: real interest rate too high I have already said that, in the case of a binding zero lower bound for the interest rate, the real interest rate is too high compared to the level appropriate to stabilise inflation around the inflation target and at the same time stabilise the real economy. To be precise, it is the real market rate, that is the market rate met by households and firms minus expected inflation, that is too high. The market rate exceeds the repo rate with a spread that is determined by  3  See Svensson, Lars E.O. (2003), "Escaping from a Liquidity Trap and Deflation: The Foolproof Way and Others," Journal of Economic Perspectives 17(4), 145-166, for literature references and a review of this research. My own contribution to this research can be found on my website, www.princeton.edu/svensson. 2  BIS Review 19/2009  various risk and liquidity premia. This spread is now unusually large due to the financial crisis. This means that the market rates are positive even if the repo rate is zero. With some simplification, the real market rate can be specified as: Real market rate  = Nominal market rate – expected inflation = Repo rate + spread – expected inflation. Even if the repo rate is reduced to zero, the real market rate can be too high, because the spread is large and/or because the expected inflation is low. 4 The real market interest rate can thus be lowered, if the spread can be reduced.
The real economy would also be stimulated directly by the fact that exporting and import-competing sectors would be affected positively by the short-term real depreciation that would arise due to the short-term sluggishness of the price level. As the price level moves up towards the price level target, the real exchange rate will, however, return to its neutral level. Does this method represent a competitive devaluation? The answer is that this is no more of a competitive devaluation than any other form of monetary policy expansion. Note that if the zero lower bound for the interest rate did not exist, the central bank could reduce the real interest rate by reducing the nominal rate. This nominal rate reduction would lead to a depreciation of the currency. The currency depreciation in part (2) achieves the same currency depreciation directly instead of indirectly via a reduction of the nominal interest rate. The method is thus no more of a competitive devaluation than a reduction of the nominal interest rate would be, if such a reduction were possible. It is quite simply a method that entails a certain degree of monetary policy expansion, but by using means other than the policy rate. Every measure that managed to increase expectations of the future price level would in fact also automatically lead to a weakening of the currency. Using the exchange rate as a policy instrument should therefore not be seen as more controversial than using any other method that leads to expectations of a higher future price level.