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Imperfect credibility and the zero lower bound on the nominal interest rate

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  • Martin Bodenstein
  • James Hebden
  • Ricardo Nunes

Abstract

When the nominal interest rate reaches its zero lower bound, credibility is crucial for conducting forward guidance. We determine optimal policy in a New Keynesian model when the central bank has imperfect credibility and cannot set the nominal interest rate below zero. In our model, an announcement of a low interest rate for an extended period does not necessarily reflect high credibility. Even if the central bank does not face a temptation to act discretionarily in the current period, policy commitments should not be postponed. In reality, central banks are often reluctant to allow a recovery path with output and inflation temporarily above target. From the perspective of our model such a policy reflects a low degree of credibility. We find increased forecast uncertainty in inflation and the output gap at the zero lower bound while interest rate uncertainty is reduced. Furthermore, misalignments between announced interest rate paths and market expectations are found to be best explained by lack of credibility.

Suggested Citation

  • Martin Bodenstein & James Hebden & Ricardo Nunes, 2010. "Imperfect credibility and the zero lower bound on the nominal interest rate," International Finance Discussion Papers 1001, Board of Governors of the Federal Reserve System (U.S.).
  • Handle: RePEc:fip:fedgif:1001
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    References listed on IDEAS

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    1. Schmitt-Grohe, Stephanie & Uribe, Martin, 2007. "Optimal simple and implementable monetary and fiscal rules," Journal of Monetary Economics, Elsevier, vol. 54(6), pages 1702-1725, September.
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    Cited by:

    1. Martin Bodenstein & Christopher J. Erceg & Luca Guerrieri, 2017. "The effects of foreign shocks when interest rates are at zero," Canadian Journal of Economics, Canadian Economics Association, vol. 50(3), pages 660-684, August.
    2. Dennis, Richard, 2014. "Imperfect credibility and robust monetary policy," Journal of Economic Dynamics and Control, Elsevier, vol. 44(C), pages 218-234.
    3. Ngo, Phuong V., 2015. "Household leverage, housing markets, and macroeconomic fluctuations," Journal of Macroeconomics, Elsevier, vol. 44(C), pages 191-207.
    4. Hatcher, Michael C., 2011. "Comparing inflation and price-level targeting: A comprehensive review of the literature," Cardiff Economics Working Papers E2011/22, Cardiff University, Cardiff Business School, Economics Section.
    5. Ngo, Phuong V., 2014. "Optimal discretionary monetary policy in a micro-founded model with a zero lower bound on nominal interest rate," Journal of Economic Dynamics and Control, Elsevier, vol. 45(C), pages 44-65.
    6. Jones, Callum & Kulish, Mariano, 2013. "Long-term interest rates, risk premia and unconventional monetary policy," Journal of Economic Dynamics and Control, Elsevier, vol. 37(12), pages 2547-2561.

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    Keywords

    Monetary policy; Interest rates; Liquidity (Economics);
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