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Expectations formation and the effectiveness of strategies for limiting the consequences of the zero bound on interest rates

  • David L. Reifschneider
  • John M. Roberts

We use simulations of the Federal Reserve's FRB/US model to examine the efficacy of a number of proposals for reducing the consequences of the zero bound on nominal interest rates. Among the proposals are: a more aggressive monetary policy; promises to make up any shortfall in monetary ease during the zero-bound period by keeping interest rates lower in the future; and the adoption of a price-level target. We consider two assumptions about expectations formation. One assumption is fully model-consistent expectations (MCE)--a reasonable assumption when a policy has been in place for some time, but perhaps less so for a newly announced policy. We therefore also consider the possibility that only financial markets have MCE, and that other agents form their expectations using a small-scale VAR model estimated using historical data. All of the policies noted above are highly effective at reducing the adverse effects of the zero bound under MCE, but their efficacy drops considerably when households and firms base their expectations on the historical average behavior of the economy, and only investors fully recognize the economic implications of the various proposals.

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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 2005-70.

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Date of creation: 2005
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Handle: RePEc:fip:fedgfe:2005-70
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  1. Yates, Tony, 2002. "Monetary policy and the zero bound to interest rates: a review," Working Paper Series 0190, European Central Bank.
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  15. Elmendorf, Douglas W. & Reifschneider, David L., 2002. "Short-Run Effects of Fiscal Policy with Forward-Looking Financial Markets," National Tax Journal, National Tax Association, vol. 55(3), pages 357-86, September.
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  17. English William B. & Nelson William R. & Sack Brian P., 2003. "Interpreting the Significance of the Lagged Interest Rate in Estimated Monetary Policy Rules," The B.E. Journal of Macroeconomics, De Gruyter, vol. 3(1), pages 1-18, April.
  18. Dale W. Henderson & Warwick J. McKibbin, 1993. "A comparison of some basic monetary policy regimes for open economies: implications of different degrees of instrument adjustment and wage persistence," International Finance Discussion Papers 458, Board of Governors of the Federal Reserve System (U.S.).
  19. Peter Isard & Douglas Laxton & Ann-Charlotte Eliasson, 1999. "Simple Monetary Policy Rules Under Model Uncertainty," Computing in Economics and Finance 1999 841, Society for Computational Economics.
  20. Ben S. Bernanke & Vincent R. Reinhart & Brian P. Sack, 2004. "Monetary policy alternatives at the zero bound: an empirical assessment," Finance and Economics Discussion Series 2004-48, Board of Governors of the Federal Reserve System (U.S.).
  21. James Clouse & Dale Henderson & Athanasios Orphanides & David Small & Peter Tinsley, 2000. "Monetary policy when the nominal short-term interest rate is zero," Finance and Economics Discussion Series 2000-51, Board of Governors of the Federal Reserve System (U.S.).
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  23. Andrew T.. Levin & Volker Wieland & John Williams, 1999. "Robustness of Simple Monetary Policy Rules under Model Uncertainty," NBER Chapters, in: Monetary Policy Rules, pages 263-318 National Bureau of Economic Research, Inc.
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