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An interest rate rule to uniquely implement the optimal equilibrium in a liquidity trap

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Abstract

We propose a new interest rate rule that implements the optimal equilibrium and eliminates all indeterminacy in a canonical New Keynesian model in which the zero lower bound on nominal interest rates (ZLB) is binding. The rule commits to zero nominal interest rates for a length of time that increases in proportion to how much past inflation has deviated?either upward or downward?from its optimal level. Once outside the ZLB, interest rates follow a standard Taylor rule. Following the Taylor principle outside the ZLB is neither necessary nor sufficient to ensure uniqueness of equilibria. Instead, the key principle is to respond strongly enough to deviations of past inflation from optimal levels by sufficiently increasing the amount of time interest rates are promised to be kept at zero.

Suggested Citation

  • Fernando M. Duarte & Anna Zabai, 2015. "An interest rate rule to uniquely implement the optimal equilibrium in a liquidity trap," Staff Reports 745, Federal Reserve Bank of New York.
  • Handle: RePEc:fip:fednsr:745
    Note: The full text of this report is no longer available. For related work, see Fernando Duarte, “How to Escape a Liquidity Trap with Interest Rate Rules,” Federal Reserve Bank of New York Staff Reports, no. 776, May 2016.
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    More about this item

    Keywords

    indeterminacy; monetary policy; zero lower bound; forward guidance; zero lower bound (ZLB); Taylor principle; liquidity traps; interest rate rules; Taylor rule; New Keynesian model;
    All these keywords.

    JEL classification:

    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects

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