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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 ‘pre-emptive easing’ is optimal because expectations of a possibly binding bound in the future amplify the effects of adverse shocks. Calibrating the model to the US 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.

Suggested Citation

  • Adam, Klaus & Billi, Roberto M, 2004. "Optimal Monetary Policy Under Discretion with a Zero Bound on Nominal Interest Rates," CEPR Discussion Papers 4585, C.E.P.R. Discussion Papers.
  • Handle: RePEc:cpr:ceprdp:4585
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    References listed on IDEAS

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    More about this item

    Keywords

    C63; liquidity trap; nonlinear policy; zero lower bound;

    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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