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

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  • Claude Lavoie
  • Hope Pioro
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    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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    Bibliographic Info

    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
    Date of revision:
    Handle: RePEc:bca:bocadp:07-1

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    Related research

    Keywords: Inflation: costs and benefits; Interest rates; Monetary policy framework;

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    1. Coenen, Günter & Orphanides, Athanasios & Wieland, Volker, 2003. "Price stability and monetary policy effectiveness when nominal interest rates are bounded at zero," CFS Working Paper Series 2003/13, Center for Financial Studies (CFS).
    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.
    3. David Reifschneider & John C. Williams, 1999. "Three lessons for monetary policy in a low inflation era," Finance and Economics Discussion Series 1999-44, Board of Governors of the Federal Reserve System (U.S.).
    4. Jeff Fuhrer & Brian Madigan, 1994. "Monetary policy when interest rates are bounded at zero," Working Papers in Applied Economic Theory 94-06, Federal Reserve Bank of San Francisco.
    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.
    6. 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.
    7. Bernard Babineau & Claude Lavoie & Nicolas Moreau, . "Risques et conséquences d’atteindre la borne inférieure du taux d’intérêt nominal de court terme," Working Papers-Department of Finance Canada 2001-22, Department of Finance Canada.
    8. 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.
    9. Stephen Murchison & Andrew Rennison, 2006. "ToTEM: The Bank of Canada's New Quarterly Projection Model," Technical Reports 97, Bank of Canada.
    10. Jean-Philippe Cayen & Amy Corbett & Patrick Perrier, 2006. "An Optimized Monetary Policy Rule for ToTEM," Working Papers 06-41, Bank of Canada.
    11. 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(1), pages 139-235.
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