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Optimal and Simple Monetary Policy Rules with Zero Floor on the Nominal Interest Rate

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  • Anton Nakov

    ()
    (Banco de España
    Universitat Pompeu Fabra)

Abstract

Recent treatments of the issue of a zero floor on nominal interest rates have been subject to some important methodological limitations. These include the assumption of perfect foresight or the introduction of the zero lower bound as an initial condition or a constraint on the variance of the interest rate, rather than an occasionally binding non-negativity constraint. This paper addresses these issues offering a global solution to a standard dynamic stochastic sticky price model with an explicit occasionally binding non-negativity constraint on the nominal interest rate. It turns out that the dynamics and sometimes the unconditional means of the nominal rate, inflation and the output gap are strongly affected by uncertainty in the presence of the zero lower bound. Commitment to the optimal rule reduces unconditional welfare losses to around one-tenth of those achievable under discretionary policy, while constant price level targeting delivers losses which are only 60% larger than under the optimal rule. Even though the unconditional performance of simple instrument rules is almost unaffected by the presence of the zero lower bound, conditional on a strong deflationary shock simple instrument rules perform substantially worse than the optimal policy.

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File URL: http://www.bde.es/f/webbde/SES/Secciones/Publicaciones/PublicacionesSeriadas/DocumentosTrabajo/06/Fic/dt0637e.pdf
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Bibliographic Info

Paper provided by Banco de Espa�a in its series Banco de Espa�a Working Papers with number 0637.

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Length: 52 pages
Date of creation: Dec 2006
Date of revision:
Handle: RePEc:bde:wpaper:0637

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Keywords: monetary policy; zero floor; interest rate;

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  1. 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.
  2. Lawrence J. Christiano & Martin Eichenbaum & Charles L. Evans, 2005. "Nominal Rigidities and the Dynamic Effects of a Shock to Monetary Policy," Journal of Political Economy, University of Chicago Press, vol. 113(1), pages 1-45, February.
  3. Kydland, Finn E & Prescott, Edward C, 1977. "Rules Rather Than Discretion: The Inconsistency of Optimal Plans," Journal of Political Economy, University of Chicago Press, vol. 85(3), pages 473-91, June.
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  7. Adam, Klaus & Billi, Roberto M., 2006. "Optimal Monetary Policy under Commitment with a Zero Bound on Nominal Interest Rates," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 38(7), pages 1877-1905, October.
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  14. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
  15. Ryo Kato & Shinichi Nishiyama, 2001. "Optimal Monetary Policy When Interest Rates are Bound at Zero," Working Papers 01-12, Ohio State University, Department of Economics.
  16. 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.
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  20. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 195-214, December.
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