Monetary Policy and the Yield Curve at Zero Interest: The Macro-Finance Model of Interest Rates as Options

A macro-finance model combined with Black's (1995) model of interest rates as options is employed to investigate the relationship between the yield curve and monetary policy under Japan's zero interest rate environment. The results indicate a strong effect on nominal yields, but not on real yields, under current Bank of Japan policy. This is because the zero rate creates a close link between real yields and expected inflation rates, which are harder to control than expected nominal short rates are. The results also indicate a very flat real yield curve, one that is more stable than the nominal one.