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

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  • Adam, Klaus
  • Billi, Roberto M.

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 ?nd the easing effect to be quantitatively important. Moreover, signi?cant welfare losses. Losses increase further when in?ation is partly determined by lagged in?ation in the Phillips curve. Targeting positive in?ation 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 signi?cant and are much larger than in the case without lower bound. JEL Classification: C63 , E31 , E52

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Bibliographic Info

Paper provided by European Central Bank in its series Working Paper Series with number 0380.

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Date of creation: Aug 2004
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Handle: RePEc:ecb:ecbwps:20040380

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Keywords: liquidity trap; nonlinear policy; zero lower bound;

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  1. Stefania Albanesi & V. V. Chari & Lawrence J. Christiano, 2003. "Expectation Traps and Monetary Policy," Review of Economic Studies, Oxford University Press, vol. 70(4), pages 715-741.
  2. Klaus Adam & Roberto M. Billi, 2005. "Optimal monetary policy under commitment with a zero bound on nominal interest rates," Research Working Paper RWP 05-07, Federal Reserve Bank of Kansas City.
  3. 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.
  4. Lawrence J. Christiano & Jonas D.M. Fisher, 1997. "Algorithms for solving dynamic models with occasionally binding constraints," Working Paper 9711, Federal Reserve Bank of Cleveland.
  5. Robert J. Barro & David B. Gordon, 1981. "A Positive Theory of Monetary Policy in a Natural-Rate Model," NBER Working Papers 0807, National Bureau of Economic Research, Inc.
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Cited by:
  1. Klaus Adam & Roberto M. Billi, 2005. "Optimal monetary policy under commitment with a zero bound on nominal interest rates," Research Working Paper RWP 05-07, Federal Reserve Bank of Kansas City.
  2. Loisel, O., 2005. "Central Bank Reputation in a Forward-Looking Model," Working papers 127, Banque de France.
  3. Anton Nakov, 2006. "Optimal and Simple Monetary Policy Rules with Zero Floor on the Nominal Interest Rate," Banco de Espa�a Working Papers 0637, Banco de Espa�a.
  4. Oda, Nobuyuki & Nagahata, Takashi, 2008. "On the function of the zero interest rate commitment: Monetary policy rules in the presence of the zero lower bound on interest rates," Journal of the Japanese and International Economies, Elsevier, vol. 22(1), pages 34-67, March.
  5. 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.

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