Optimal Monetary Policy Under Discretion with a Zero Bound on Nominal Interest Rates
46 Pages Posted: 9 Dec 2004
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Optimal Monetary Policy Under Discretion with a Zero Bound on Nominal Interest Rates
Optimal Monetary Policy Under Discretion with a Zero Bound on Nominal Interest Rates
Date Written: August 2004
Abstract
We determine optimal discretionary monetary policy in a New-Keynesian model when nominal interest rates are bounded below by zero. Nominal interest rates should be lowered faster in response to adverse shocks than in the case without bound. Such "preemptive easing" is optimal because expectations of a possibly binding bound in the future amplify the effects of adverse shocks. Calibrating the model to the U.S. economy we find the easing effect to be quantitatively important. Moreover, significant welfare losses. Losses increase further when inflation is partly determined by lagged inflation in the Phillips curve. Targeting positive inflation rates reduces the frequency of a binding lower bound, but tends to reduce welfare compared to a target rate of zero. The welfare gains from policy commitment, however, appear significant and are much larger than in the case without lower bound.
Keywords: nonlinear policy, zero lower bound, liquidit y trap
JEL Classification: C63, E31, E52
Suggested Citation: Suggested Citation
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