The zero-lower bound on interest rates: Myth or reality?

- Review traditional HJM without cash.
- Extend the HJM to include trading in cash, using a convenience yield.
- Show that an HJM model with cash allows negative interest rates with positive probability.

Unconventional monetary policy tools are based on the belief that there exists a zero-lower bound on interest rates. This paper argues, based on economic theory and the empirical evidence, that this belief is a myth and not a reality. It is shown that a negative default-free spot rate of interest is consistent with an arbitrage-free term structure evolution in a competitive and nearly frictionless market. It is not frictionless to the extent that consumers, firms, non-bank financial institutions, and banks have some realistic constraints imposed on their trading activities.