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Discretionary Monetary Policy and the Zero Lower Bound on Nominal Interest Rates

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Ignoring the existence of the zero lower bound on nominal interest rates one considerably understates the value of monetary commitment in New Keynesian models. A stochastic forward-looking model with lower bound, calibrated to the U.S. economy, suggests that low values for the natural rate of interest lead to sizeable output losses and deflation under discretionary monetary policy. The fall in output and deflation are much larger than in the case with policy commitment and do not show up at all if the model abstracts from the existence of the lower bound. The welfare losses of discretionary policy increase even further when inflation is partly determined by lagged inflation in the Phillips curve. These results emerge because private sector expectations and the discretionary policy response to these expectations reinforce each other and cause the lower bound to be reached much earlier than under commitment.

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  • Klaus Adam & Roberto Billi, 2005. "Discretionary Monetary Policy and the Zero Lower Bound on Nominal Interest Rates," CFS Working Paper Series 2005/16, Center for Financial Studies.
  • Handle: RePEc:cfs:cfswop:wp200516
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    More about this item

    Keywords

    Nonlinear Optimal Policy; Occasionally Binding Constraint; Sequential Policy; Markov Perfect Equilibrium; Liquidity Trap;
    All these keywords.

    JEL classification:

    • 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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