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

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Author Info
Klaus Adam () (European Central Bank, DG Research)
Roberto M. Billi () (Center for Financial Studies)

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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.

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Paper provided by European Central Bank in its series Working Paper Series with number 377.

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Length: 53 pages
Date of creation: Jul 2004
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Handle: RePEc:ecb:ecbwps:20040377

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Related research
Keywords: nonlinear optimal policy; zero interest rate bound; commitment; liquidity trap; New Keynesian.;

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Find related papers by JEL classification:
C63 - Mathematical and Quantitative Methods - - Mathematical Methods and Programming - - - Computational Techniques
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

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