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Optimal monetary policy under discretion 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 discretionary monetary policy in a New-Keynesian model when nominal interest rates are bounded below by zero. Nominal interest rates should be lowered faster in response to adverse shocks than in the case without bound. Such ‘preemptive easing’ is optimal because expectations of a possibly binding bound in the future amplify the effects of adverse shocks. Calibrating the model to the U.S. economy we find the easing effect to be quantitatively important. Moreover, the lower bound binds rather frequently and imposes significant welfare losses. Losses increase further when inflation is partly determined by lagged inflation in the Phillips curve. Targeting positive inflation rates reduces the frequency of a binding lower bound, but tends to reduce welfare compared to a target rate of zero. The welfare gains from policy commitment, however, appear significant and are much larger than in the case without lower bound.

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Paper provided by European Central Bank in its series Working Paper Series with number 380.

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Length: 44 pages
Date of creation: Aug 2004
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Handle: RePEc:ecb:ecbwps:20040380

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Related research
Keywords: nonlinear policy; zero lower bound; liquidity trap.;

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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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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Alan J. Auerbach & Maurice Obstfeld, 2003. "The Case for Open-Market Purchases in a Liquidity Trap," NBER Working Papers 9814, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  2. Barro, Robert J & Gordon, David B, 1983. "A Positive Theory of Monetary Policy in a Natural Rate Model," Journal of Political Economy, University of Chicago Press, vol. 91(4), pages 589-610, August. [Downloadable!] (restricted)
    Other versions:
  3. Roberto M. Billi & Klaus Adam, 2004. "Optimal Monetary Policy under Commitment with a Zero Bound on Nominal Interest Rates," Computing in Economics and Finance 2004 67, Society for Computational Economics. [Downloadable!]
    Other versions:
  4. Stefania Albanesi & V.V. Chari & Lawrence J. Christiano, 2002. "Expectation Traps and Monetary Policy," NBER Working Papers 8912, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  5. Lawrence J. Christiano & Jonas D. M. Fisher, 1994. "Algorithms for solving dynamic models with occasionally binding constraints," Staff Report 171, Federal Reserve Bank of Minneapolis. [Downloadable!]
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Klaus Adam & Roberto M. Billi, 2004. "Optimal Monetary Policy under Commitment with a Zero Bound on Nominal Interest Rates," CFS Working Paper Series 2004/13, Center for Financial Studies. [Downloadable!]
    Other versions:
  2. Anton Nakov, 2006. "Optimal and Simple Monetary Policy Rules with Zero Floor on the Nominal Interest Rate," Banco de España Working Papers 0637, Banco de España. [Downloadable!]
    Other versions:
  3. Michał Brzoza-Brzezina & Jacek Socha, 2007. "Downward nominal wage rigidity in Poland," National Bank of Poland Working Papers 41, National Bank of Poland, Economic Institute. [Downloadable!]
    Other versions:
  4. Loisel, O., 2005. "Central Bank Reputation in a Forward-Looking Model," Documents de Travail 127, Banque de France. [Downloadable!]
    Other versions:
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