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Optimal monetary policy under commitment with a zero bound on nominal interest rates

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  • Adam, Klaus
  • Billi, Roberto M.

Abstract

We determine optimal monetary policy under commitment in a forwardlooking New Keynesian model when nominal interest rates are bounded below by zero. The lower bound represents an occasionally binding constraint that causes the model and optimal policy to be nonlinear. A calibration to the U.S. economy suggests that policy should reduce nominal interest rates more aggressively than suggested by a model without lower bound. Rational agents anticipate the possibility of reaching the lower bound in the future and this amplifies the effects of adverse shocks well before the bound is reached. While the empirical magnitude of U.S. mark-up shocks seems too small to entail zero nominal interest rates, shocks affecting the natural real interest rate plausibly lead to a binding lower bound. Under optimal policy, however, this occurs quite infrequently and does not require targeting a positive average rate of inflation. JEL Classification: C63, E31, E52

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Paper provided by European Central Bank in its series Working Paper Series with number 0377.

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Date of creation: Jul 2004
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Handle: RePEc:ecb:ecbwps:20040377

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Keywords: commitment; liquidity trap; New Keynesian; Nonlinear optimal policy; zero interest rate bound;

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