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Gradualism and liquidity traps

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  • Schmidt, Sebastian
  • Nakata, Taisuke

Abstract

Modifying the objective function of a discretionary central bank to include an interest-rate smoothing objective increases the welfare of an economy where large contractionary shocks occasionally force the central bank to lower the policy rate to its effective lower bound. The central bank with an interest-rate smoothing objective credibly keeps the policy rate low for longer than the central bank with the standard objective function does. Through expectations, the temporary overheating of the economy associated with such low-for-long interest rate policy mitigates the declines in inflation and output when the lower bound constraint is binding. In a calibrated model, we find that the introduction of an interest-rate smoothing objective can reduce the welfare costs associated with the lower bound constraint by more than half. JEL Classification: E52, E61

Suggested Citation

  • Schmidt, Sebastian & Nakata, Taisuke, 2016. "Gradualism and liquidity traps," Working Paper Series 1976, European Central Bank.
  • Handle: RePEc:ecb:ecbwps:20161976
    Note: 2179645
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    References listed on IDEAS

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    Cited by:

    1. Jason Choi & Andrew Foerster, . "Optimal Monetary Policy Regime Switches," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics.
    2. Jordi Galí, 2018. "The State of New Keynesian Economics: A Partial Assessment," Journal of Economic Perspectives, American Economic Association, vol. 32(3), pages 87-112, Summer.
    3. Nakata, Taisuke & Schmidt, Sebastian, 2019. "Conservatism and liquidity traps," Journal of Monetary Economics, Elsevier, vol. 104(C), pages 37-47.
    4. de Groot, Oliver & Haas, Alexander, 2019. "The Signalling Channel of Negative Interest Rates," MPRA Paper 95479, University Library of Munich, Germany.
    5. Kohei Hasui & Teruyoshi Kobayashi & Tomohiro Sugo, 2019. "Irreversible monetary policy at the zero lower bound," Discussion Papers 1906, Graduate School of Economics, Kobe University.
    6. Thomas M. Mertens & John C. Williams, 2019. "Monetary Policy Frameworks and the Effective Lower Bound on Interest Rates," AEA Papers and Proceedings, American Economic Association, vol. 109, pages 427-432, May.
    7. Schmidt, Sebastian, 2018. "The effective lower bound and the desirability of gradual interest rate adjustments," Research Bulletin, European Central Bank, vol. 45.
    8. Thomas M. Mertens & John C. Williams, 2019. "Tying Down the Anchor: Monetary Policy Rules and the Lower Bound on Interest Rates," Working Paper Series 2019-14, Federal Reserve Bank of San Francisco.
    9. Hills, Timothy S. & Nakata, Taisuke & Schmidt, Sebastian, 2019. "Effective lower bound risk," European Economic Review, Elsevier, vol. 120(C).
    10. Hasui, Kohei & Kobayashi, Teruyoshi & Sugo, Tomohiro, 2021. "Optimal irreversible monetary policy," European Economic Review, Elsevier, vol. 134(C).

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    More about this item

    Keywords

    gradualism; inflation targeting; interest-rate smoothing; Liquidity Traps; zero lower bound;
    All these keywords.

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies

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