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The Zero Bound on Nominal Interest Rates: Implications for the Optimal Monetary Policy in Canada

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Author Info
Claude Lavoie
Hope Pioro
Abstract

The authors assess the performance of the Canadian economy under a variety of interest rate rules when the zero bound on nominal interest rates can bind. Their assessment is based on numerical simulations of a dynamic stochastic general-equilibrium model in a stochastic environment. Consistent with the literature, the authors find that the probability and consequences of the zero bound depend strongly on the targeted rate of inflation and that price-level targeting generally leads to better outcomes. Their results show that a non-linear rule is preferable to a linear rule under both inflation and price-level targeting, because of the zero-bound issue. This suggests that central banks should be pre-emptive and adopt an aggressive monetary policy when expected inflation falls below its desired level. The authors' results also show that the monetary authority must be much more forward looking under price-level targeting than under inflation targeting.

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File URL: http://www.bankofcanada.ca/en/res/dp/2007/dp07-1.pdf
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Paper provided by Bank of Canada in its series Discussion Papers with number 07-1.

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Length: 24 pages
Date of creation: 2007
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Handle: RePEc:bca:bocadp:07-1

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Related research
Keywords: Inflation: costs and benefits Interest rates Monetary policy framework

Find related papers by JEL classification:
E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Determination of Interest Rates; Term Structure of Interest Rates
E47 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Forecasting and Simulation
E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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References listed on IDEAS
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  1. Reifschneider, David & Willams, John C, 2000. "Three Lessons for Monetary Policy in a Low-Inflation Era," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 32(4), pages 936-66, November.
  2. Kato, Ryo & Nishiyama, Shin-Ichi, 2005. "Optimal monetary policy when interest rates are bounded at zero," Journal of Economic Dynamics and Control, Elsevier, vol. 29(1-2), pages 97-133, January. [Downloadable!] (restricted)
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  3. David Reifschneider & John C. Williams, 2000. "Three lessons for monetary policy in a low-inflation era," Conference Series ; [Proceedings], Federal Reserve Bank of Boston, pages 936-978.
    Other versions:
  4. Gauti B. Eggertsson & Michael Woodford, 2003. "The Zero Bound on Interest Rates and Optimal Monetary Policy," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 34(2003-1), pages 139-235. [Downloadable!]
  5. Summers, Lawrence, 1991. "How Should Long-Term Monetary Policy Be Determined? Panel Discussion," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 23(3), pages 625-31, August. [Downloadable!] (restricted)
  6. Athanasios Orphanides & Volker Wieland, 1998. "Price stability and monetary policy effectiveness when nominal interest rates are bounded at zero," Finance and Economics Discussion Series 1998-35, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
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  7. Jeffrey C. Fuhrer & Brian F. Madigan, 1997. "Monetary Policy When Interest Rates Are Bounded At Zero," The Review of Economics and Statistics, MIT Press, vol. 79(4), pages 573-585, November. [Downloadable!] (restricted)
    Other versions:
  8. Alexander L. Wolman, 1998. "Staggered price setting and the zero bound on nominal interest rates," Economic Quarterly, Federal Reserve Bank of Richmond, issue Fall, pages 1-24. [Downloadable!]
  9. Jean-Philippe Cayen & Amy Corbett & Patrick Perrier, 2006. "An Optimized Monetary Policy Rule for ToTEM," Working Papers 06-41, Bank of Canada. [Downloadable!]
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