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Price Stability and Monetary Policy Effectiveness when Nominal Interest Rates are Bounded at Zero

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Author Info
Guenter Coenen () (European Central Bank)
Athanasios Orphanides () (Board of Governors of the Federal Reserve System, Washington)
Volker Wieland () (Goethe University Frankfurt and CFS)

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Abstract

This paper employs stochastic simulations of a small structural rational expectations model to investigate the consequences of the zero bound on nominal interest rates. We find that if the economy is subject to stochastic shocks similar in magnitude to those experienced in the U.S. over the 1980s and 1990s, the consequences of the zero bound are negligible for target inflation rates as low as 2 percent. However, the effects of the constraint are non-linear with respect to the inflation target and produce a quantitatively significant deterioration of the performance of the economy with targets between 0 and 1 percent. The variability of output increases significantly and that of inflation also rises somewhat. Also, we show that the asymmetry of the policy ineffectiveness induced by the zero bound generates a non-vertical long-run Phillips curve. Output falls increasingly short of potential with lower inflation targets.

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Paper provided by Center for Financial Studies in its series CFS Working Paper Series with number 2003/13.

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Length: 28 pages
Date of creation: 13 Jan 2003
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Handle: RePEc:cfs:cfswop:wp200313

Note: We have benefited from presentations of earlier drafts at meetings of the Econometric Society, the European Economic Association, the Society of Economic Dynamics, the System Committee Meeting on Macro-economics, the NBER, and seminars at the University of Michigan, Rutgers University, University of Frankfurt, University of Cologne, University of St.Gallen, the European Central Bank and the Canadian Department of Finance. We would also like to thank Todd Clark, Bill English, Andrew Haldane, David Lindsey, Yvan Lengwiler, Brian Madigan, Allan Meltzer, Richard Porter, John Williams and Alex Wolman for useful comments. The opinions expressed here are those of the authors and do not necessarily reflect views of the European Central Bank or the Federal Reserve Board.
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Related research
Keywords: Inflation targeting; price stability; monetary policy rules; liquidity trap;

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Find related papers by JEL classification:
E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination

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