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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
Date of revision:
Handle: RePEc:fip:fedgfe:2005-70
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  1. James A. Clouse & Dale W. Henderson & Athanasios Orphanides & David H. Small & Peter A. 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.).
  2. Coenen, Günter & Orphanides, Athanasios & Wieland, Volker, 2003. "Price stability and monetary policy effectiveness when nominal interest rates are bounded at zero," Working Paper Series 0231, European Central Bank.
  3. Boivin, Jean & Giannoni, Marc, 2006. "Has Monetary Policy Become More Effective?," CEPR Discussion Papers 5463, C.E.P.R. Discussion Papers.
  4. Flint Brayton & Peter A. Tinsley, 1996. "A guide to FRB/US: a macroeconomic model of the United States," Finance and Economics Discussion Series 96-42, Board of Governors of the Federal Reserve System (U.S.).
  5. Henderson, Dale W. & McKibbin, Warwick J., 1993. "A comparison of some basic monetary policy regimes for open economies: implications of different degrees of instrument adjustment and wage persistence," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 221-317, December.
  6. Paul R. Krugman, 1998. "It's Baaack: Japan's Slump and the Return of the Liquidity Trap," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 29(2), pages 137-206.
  7. Gauti B. Eggertsson & Michael Woodford, 2003. "The Zero Bound on Interest Rates and Optimal Monetary Policy," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 34(1), pages 139-235.
  8. Svensson, Lars E O, 1999. "How Should Monetary Policy Be Conducted In An Era Of Price Stability?," CEPR Discussion Papers 2342, C.E.P.R. Discussion Papers.
  9. Ann-Charlotte Eliasson & Peter Isard & Douglas Laxton, 1999. "Simple Monetary Policy Rules Under Model Uncertainty," IMF Working Papers 99/75, International Monetary Fund.
  10. Ben S. Bernanke & Vincent R. Reinhart & Brian P. Sack, 2004. "Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 35(2), pages 1-100.
  11. 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.
  12. Refet S. Gürkaynak & Brian Sack & Eric Swanson, 2005. "The Sensitivity of Long-Term Interest Rates to Economic News: Evidence and Implications for Macroeconomic Models," American Economic Review, American Economic Association, vol. 95(1), pages 425-436, March.
  13. 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.
  14. Christopher J. Erceg and Andrew T. Levin, 2001. "Imperfect Credibility and Inflation Persistence," Computing in Economics and Finance 2001 19, Society for Computational Economics.
  15. Wolman, Alexander L, 2005. "Real Implications of the Zero Bound on Nominal Interest Rates," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 37(2), pages 273-96, April.
  16. John M. Roberts, 2004. "Monetary policy and inflation dynamics," Finance and Economics Discussion Series 2004-62, Board of Governors of the Federal Reserve System (U.S.).
  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. Athanasios Orphanides & John C. Williams, 2002. "Robust monetary policy rules with unknown natural rates," Working Paper Series 2003-01, Federal Reserve Bank of San Francisco.
  19. David L. Reifschneider & Robert J. Tetlow & John Williams, 1999. "Aggregate disturbances, monetary policy, and the macroeconomy: the FRB/US perspective," Federal Reserve Bulletin, Board of Governors of the Federal Reserve System (U.S.), issue Jan, pages 1-19.
  20. Donald L. Kohn & Brian P. Sack, 2003. "Central bank talk: does it matter and why?," Finance and Economics Discussion Series 2003-55, Board of Governors of the Federal Reserve System (U.S.).
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  22. Svensson, Lars E O, 1999. "Price-Level Targeting versus Inflation Targeting: A Free Lunch?," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 31(3), pages 277-95, August.
  23. repec:oup:qjecon:v:115:y:2000:i:1:p:147-180 is not listed on IDEAS
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