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The Zero Bound on Nominal Interest Rates: Implications for the Optimal Monetary Policy in Canada

  • Claude Lavoie
  • Hope Pioro
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    The authors assess the performance of the Canadian economy under a variety of interest rate rules when the zero bound on nominal interest rates can bind. Their assessment is based on numerical simulations of a dynamic stochastic general-equilibrium model in a stochastic environment. Consistent with the literature, the authors find that the probability and consequences of the zero bound depend strongly on the targeted rate of inflation and that price-level targeting generally leads to better outcomes. Their results show that a non-linear rule is preferable to a linear rule under both inflation and price-level targeting, because of the zero-bound issue. This suggests that central banks should be pre-emptive and adopt an aggressive monetary policy when expected inflation falls below its desired level. The authors' results also show that the monetary authority must be much more forward looking under price-level targeting than under inflation targeting.

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    File URL: http://www.bankofcanada.ca/en/res/dp/2007/dp07-1.pdf
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    Paper provided by Bank of Canada in its series Discussion Papers with number 07-1.

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    Length: 24 pages
    Date of creation: 2007
    Date of revision:
    Handle: RePEc:bca:bocadp:07-1
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    1. Coenen, Günter & Orphanides, Athanasios & Wieland, Volker, 2003. "Price Stability and Monetary Policy Effectiveness when Nominal Interest Rates are Bounded at Zero," CEPR Discussion Papers 3892, C.E.P.R. Discussion Papers.
    2. Summers, Lawrence, 1991. "How Should Long-Term Monetary Policy Be Determined? Panel Discussion," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 23(3), pages 625-31, August.
    3. Ryo Kato & Shinichi Nishiyama, 2001. "Optimal Monetary Policy When Interest Rates are Bound at Zero," Working Papers 01-12, Ohio State University, Department of Economics.
    4. David Reifschneider & John C. Williams, 2000. "Three lessons for monetary policy in a low-inflation era," Conference Series ; [Proceedings], Federal Reserve Bank of Boston, pages 936-978.
    5. Reifschneider, David & Willams, John C, 2000. "Three Lessons for Monetary Policy in a Low-Inflation Era," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 32(4), pages 936-66, November.
    6. Alexander L. Wolman, 1998. "Staggered price setting and the zero bound on nominal interest rates," Economic Quarterly, Federal Reserve Bank of Richmond, issue Fall, pages 1-24.
    7. Jeffrey Fuhrer & Brian Madigan, 1994. "Monetary policy when interest rates are bounded at zero," Working Papers 94-1, Federal Reserve Bank of Boston.
    8. Jean-Philippe Cayen & Amy Corbett & Patrick Perrier, 2006. "An Optimized Monetary Policy Rule for ToTEM," Working Papers 06-41, Bank of Canada.
    9. Stephen Murchison & Andrew Rennison, 2006. "ToTEM: The Bank of Canada's New Quarterly Projection Model," Technical Reports 97, Bank of Canada.
    10. Gauti B. Eggertsson & Michael Woodford, 2003. "The Zero Bound on Interest Rates and Optimal Monetary Policy," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 34(1), pages 139-235.
    11. Bernard Babineau & Claude Lavoie & Nicolas Moreau, . "Risques et conséquences d’atteindre la borne inférieure du taux d’intérêt nominal de court terme," Working Papers-Department of Finance Canada 2001-22, Department of Finance Canada.
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