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Efficient monetary policy design near price stability

  • Athanasios Orphanides
  • Volker Wieland

We study the design of monetary policy in a low inflation environment taking into account the limitations imposed by the zero bound on nominal interest rates. Using numerical dynamic programming methods, we compute optimal policies in a simple, calibrated open-economy model and evaluate the effect of the liquidity trap generated by the zero bound. We consider the possibility that the quantity of base money may affect output and inflation even when the interest rate is constrained at zero and explicitly account for the substantial degree of uncertainty regarding such quantity effects. As an example of such a quantity effect, we focus on the portfolio balance channel through which changes in relative money supplies influence the exchange rate. We find that the optimal policy near price stability is asymmetric, that is, as inflation declines, policy turns expansionary sooner and more aggressively than would be optimal in the absence of the zero bound. As a consequence, the average level of inflation is biased upwards. These results indicate that policymakers are faced with a tradeoff between the level of inflation and economic stabilization performance when the economy is operating near the zero bound. Finally, we discuss operational issues associated with the interpretation and implementation of policy at the zero bound in relation to the recent situation in Japan.

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Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 1999-67.

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Date of creation: 1999
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Handle: RePEc:fip:fedgfe:1999-67
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  1. Charles W. Calomiris, 1993. "Financial Factors in the Great Depression," Journal of Economic Perspectives, American Economic Association, vol. 7(2), pages 61-85, Spring.
  2. Laurence Ball, 1998. "Policy Rules for Open Economies," NBER Working Papers 6760, National Bureau of Economic Research, Inc.
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