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Monetary Policy Frameworks and the Effective Lower Bound on Interest Rates

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Abstract

This paper applies a standard New Keynesian model to analyze the effects of monetary policy in the presence of a low natural rate of interest and a lower bound on interest rates. Under a standard inflation-targeting approach, inflation expectations will be anchored at a level below the inflation target, which in turn exacerbates the deleterious effects of the lower bound on the economy. Two key themes emerge from our analysis. First, the central bank can mitigate this problem of a downward bias in inflation expectations by following an average-inflation targeting framework that aims for above-target inflation during periods when policy is unconstrained. Second, a dynamic strategy such as price-level targeting that raises inflation expectations when inflation is low can both anchor expectations at the target level and potentially further reduce the effects of the lower bound on the economy.

Suggested Citation

  • Mertens, Thomas M. & Williams, John C., 2019. "Monetary Policy Frameworks and the Effective Lower Bound on Interest Rates," Working Paper Series 2019-1, Federal Reserve Bank of San Francisco.
  • Handle: RePEc:fip:fedfwp:2019-01
    DOI: 10.24148/wp2019-01
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    1. Mertens, Thomas M. & Williams, John C., 2018. "What to expect from the lower bound on interest rates: evidence from derivatives prices," Staff Reports 865, Federal Reserve Bank of New York.
    2. Taisuke Nakata & Sebastian Schmidt, 2019. "Gradualism and Liquidity Traps," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 31, pages 182-199, January.
    3. Taisuke Nakata & Sebastian Schmidt, 2019. "Gradualism and Liquidity Traps," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 31, pages 182-199, January.
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    Cited by:

    1. Cecchetti, Stephen G & Schoenholtz, Kermit, 2019. "Improving U.S. Monetary Policy Communications," CEPR Discussion Papers 13915, C.E.P.R. Discussion Papers.
    2. Powell, Jerome H., 2019. "Monetary Policy: Normalization and the Road Ahead : a speech at the 2019 SIEPR Economic Summit, Stanford Institute of Economic Policy Research, Stanford, California, March 8, 2019," Speech 1044, Board of Governors of the Federal Reserve System (U.S.).
    3. Powell, Jerome H., 2019. "Opening Remarks : a speech at the "Conference on Monetary Policy Strategy, Tools, and Communications Practices" sponsored by the Federal Reserve, Federal Reserve Bank of Chicago, Chicago, Il," Speech 1070, Board of Governors of the Federal Reserve System (U.S.).
    4. Carl E. Walsh, 2019. "Alternatives to Inflation Targeting in Low Interest Rate Environments," IMES Discussion Paper Series 19-E-13, Institute for Monetary and Economic Studies, Bank of Japan.

    More about this item

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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