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Assessing the Effects of the Zero-Interest-Rate Policy through the Lens of a Regime-Switching DSGE Model

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Abstract

Standard dynamic stochastic general equilibrium (DSGE) models assume a Taylor rule and forecast an increase in interest rates immediately after the 2007-2009 economic recession given the predicted output and inflation, contradictory to the extended period of near-zero interest rate policy (ZIRP) conducted by the Federal Reserve. In this paper, I study two methods of modeling the ZIRP in DSGE models: the perfect foresight rational expectations model and the Markov regime-switching model, which I develop in this paper. In this regime-switching model, I assume that, in one regime, the policy follows a Taylor rule, while, in the other regime, it involves a zero interest rate. I also construct the optimal filter to estimate this regime-switching DSGE model with Bayesian methods. I fit those modified DSGE models to the U.S. data from the third quarter of 1987 to the third quarter of 2010, and then, starting from the fourth quarter of 2010, I simulate the U.S. economy forward with and without the ZIRP intervention. I compare the predicted paths of the macro variables, and I find that the ZIRP intervention has a significant effect. The estimated regime-switching model I develop implies a substantial stimulative effect (on average a 0.12% increase in output growth rate and a 0.9% increase in inflation accumulatively over 20 quarters if ZIRP is kept for 6 quarters). The actual path from the fourth quarter of 2010 onward is closer to the predicted path derived from the regime-switching model than that generated by the perfect foresight model. The perfect foresight model generates an explosive and spurious rise in inflation. Therefore, the regime-switching model I propose is more appropriate to assess the effectiveness of the ZIRP, which is effective in stimulating the economy.

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  • Han Chen, 2014. "Assessing the Effects of the Zero-Interest-Rate Policy through the Lens of a Regime-Switching DSGE Model," Finance and Economics Discussion Series 2014-38, Board of Governors of the Federal Reserve System (U.S.).
    • Handle: RePEc:fip:fedgfe:2014-38
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    Cited by:

    1. Andrew Binning & Junior Maih, 2017. "Modelling Occasionally Binding Constraints Using Regime-Switching," Working Paper 2017/23, Norges Bank.
    2. Kulish, Mariano & Morley, James & Robinson, Tim, 2017. "Estimating DSGE models with zero interest rate policy," Journal of Monetary Economics, Elsevier, vol. 88(C), pages 35-49.

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    Keywords

    Regime switching; zero interest rate policy; unconventional monetary policy;
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