Parameter Uncertainty and Effective Lower Bound Risk

Uncertainty is a fact of life for central banks, and the effective lower bound (ELB) of short-term nominal interest rates has become one source of uncertainty for many of them. This paper analyzes the effects of uncertainty about monetary policy transmission on inflation in a canonical New Keynesian model with optimal discretionary monetary policy under the ELB. The main finding is that a greater degree of uncertainty enlarges the "deflationary bias" of the economy. In the model, the central bank reacts to the uncertainty by attenuating the response of the nominal interest rate to exogenous shocks. Such inactive policy response leaves the fall in inflation caused by the ELB risk partially untreated, which lowers the inflation expectations of private agents and results in undershooting of the inflation target.