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Heeding Daedalus: Optimal inflation and the zero lower bound

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  • John C. Williams

Abstract

This paper reexamines the implications of the zero lower bound on interest rates for monetary policy and the optimal choice of steady-state inflation in light of the experience of the recent global recession. There are two main findings. First, the zero lower bound did not materially contribute to the sharp declines in output in the United States and many other economies through the end of 2008, but it is a significant factor slowing recovery. Model simulations imply that an additional 4 percentage points of rate cuts would have kept the unemployment rate from rising as much as it has and would bring the unemployment and inflation rates more quickly to steady-state values, but the zero bound precludes these actions. This inability to lower interest rates comes at the cost of $1.7 trillion of foregone output over four years. Second, if recent events are a harbinger of a significantly more adverse macroeconomic climate than experienced over the preceding two decades, then a 2 percent steady-state inflation rate may provide an inadequate buffer to keep the zero bound from having noticeable deleterious effects on the macroeconomy assuming the central bank follows the standard Taylor Rule. In such an adverse environment, stronger systematic countercyclical fiscal policy and/or alternative monetary policy strategies can mitigate the harmful effects of the zero bound with a 2 percent inflation target. However, even with such policies, an inflation target of 1 percent or lower could entail significant costs in terms of macroeconomic volatility.

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Paper provided by Federal Reserve Bank of San Francisco in its series Working Paper Series with number 2009-23.

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Date of creation: 2009
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Handle: RePEc:fip:fedfwp:2009-23

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Keywords: Monetary policy ; Fiscal policy ; Liquidity (Economics);

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Cited by:
  1. Günter Coenen & Anders Warne, 2014. "Risks to Price Stability, the Zero Lower Bound, and Forward Guidance: A Real-Time Assessment," International Journal of Central Banking, International Journal of Central Banking, vol. 10(2), pages 7-54, June.
  2. Michael Dooley & John C Williams, 2010. "Wrap-up Discussion," RBA Annual Conference Volume, in: Renée Fry & Callum Jones & Christopher Kent (ed.), Inflation in an Era of Relative Price Shocks Reserve Bank of Australia.
  3. Olivier Coibion & Yuriy Gorodnichenko & Johannes Wieland, 2010. "The Optimal Inflation Rate in New Keynesian Models," Working Papers 91, Department of Economics, College of William and Mary.
  4. Axel A. Weber, 2011. "Challenges for monetary policy in the European Monetary Union," Review, Federal Reserve Bank of St. Louis, issue July, pages 235-242.
  5. Gerlach, Stefan & Lewis, John, 2011. "ECB Reaction Functions and the Crisis of 2008," CEPR Discussion Papers 8472, C.E.P.R. Discussion Papers.
  6. R. Gerke & F. Hammermann & V. Lewis, 2011. "Robust Monetary Policy in a Model with Financial Distress," Working Papers of Faculty of Economics and Business Administration, Ghent University, Belgium 11/767, Ghent University, Faculty of Economics and Business Administration.
  7. Henning Weber, 2011. "Optimal inflation and firms' productivity dynamics," Kiel Working Papers 1685, Kiel Institute for the World Economy.
  8. Gerke, Rafael & Hammermann, Felix & Lewis, Vivien, 2012. "Robust monetary policy in a model with financial distress," Journal of Macroeconomics, Elsevier, vol. 34(2), pages 318-325.
  9. Tambakis, Demosthenes N., 2014. "On the risk of long-run deflation," Economics Letters, Elsevier, vol. 122(2), pages 176-181.
  10. Olmos, Lorena & Sanso Frago, Marcos, 2014. "Natural Rate of Interest with Endogenous Growth, Financial Frictions and Trend Inflation," MPRA Paper 57212, University Library of Munich, Germany.
  11. Magill, Michael & Quinzii, Martine, 2014. "Anchoring expectations of inflation," Journal of Mathematical Economics, Elsevier, vol. 50(C), pages 86-105.
  12. Bennett T. McCallum, 2011. "Should central banks raise their inflation targets? Some relevant issues," Economic Quarterly, Federal Reserve Bank of Richmond, issue 2Q, pages 111-131.
  13. Guido Ascari & Argia M. Sbordone, 2013. "The macroeconomics of trend inflation," Staff Reports 628, Federal Reserve Bank of New York.
  14. Jean Louis, Rosmy & Balli, Faruk, 2013. "Low-inflation-targeting monetary policy and differential unemployment rate: Is monetary policy to be blamed for the financial crisis? — Evidence from major OECD countries," Economic Modelling, Elsevier, vol. 30(C), pages 546-564.

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