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Financial frictions and the zero lower bound on interest rates: a DSGE analysis

  • Merola, Rossana

Recent developments in Canada, the United Kingdom, the euro area, Japan, Sweden, Switzerland and the United States have triggered a debate on whether monetary policy is effective when the nominal interest rate is close to zero. In this context, the monetary authority is no longer in a position to pursue a policy of monetary easing by lowering nominal interest rates further. However, some economists have down-played the risk of hitting the zero lower bound, at least for the US economy. In this paper, I assess the implications of the zero lower bound in a DSGE model with financial frictions. The financial accelerator mechanism is formalized as in Bernanke, Gertler and Gilchrist (1995). The paper attempts to address three main issues. First, I evaluate whether the zero lower bound -- by limiting the use of the nominal interest rate as a policy instrument -- might hamper the monetary authority from offsetting the negative effects of an adverse shock. Second, I analyze whether price-level targeting, through the stabilization of private sector expectations, might be a better monetary rule than inflation targeting in order to avoid the "liquidity trap". Third, I investigate the effectiveness of fiscal stimulus (namely, an increase in government expenditure) when financial markets are imperfect and the nominal interest rate is close to its zero lower bound. In this context, two questions will be addressed: first, do financial frictions weaken the effect of a fiscal expansion? Second, how are results affected when the zero lower bound is binding? To address these questions, I introduce a negative demand shock and an adverse financial shock. I find that by adopting a price-level targeting rule, the monetary authority might alleviate the recession generated by the interaction of financial frictions and lower-bounded nominal interest rates. Alternatively, an increase in government expenditure has a positive impact on output, but fiscal multipliers are below one, due to a strong crowding-out effect of private consumption. This effect is muted when the nominal interest rate is lower bounded. In analyzing discretionary fiscal policy, this paper does also focus on two crucial aspects: the duration of the fiscal stimulus and the presence of implementation lags.

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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 29365.

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Date of creation: Jul 2010
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Handle: RePEc:pra:mprapa:29365
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  1. 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.
  2. Lars E. O. Svensson, 1999. "How should monetary policy be conducted in an era of price stability?," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 195-259.
  3. Svensson, Lars-E-O, 2001. "The Zero Bound in an Open Economy: A Foolproof Way of Escaping from a Liquidity Trap," Monetary and Economic Studies, Institute for Monetary and Economic Studies, Bank of Japan, vol. 19(S1), pages 277-312, February.
  4. Frederic S. Mishkin & Klaus Schmidt-Hebbel D., 2006. "Monetary Policy Under Inflation Targeting: An Introduction," Journal Economía Chilena (The Chilean Economy), Central Bank of Chile, vol. 9(3), pages 5-17, December.
  5. Cogan, John F. & Cwik, Tobias & Taylor, John B. & Wieland, Volker, 2010. "New Keynesian versus old Keynesian government spending multipliers," Journal of Economic Dynamics and Control, Elsevier, vol. 34(3), pages 281-295, March.
  6. Jesús Fernández-Villaverde, 2010. "Fiscal Policy in a Model with Financial Frictions," American Economic Review, American Economic Association, vol. 100(2), pages 35-40, May.
  7. Francisco Covas & Yahong Zhang, 2010. "Price-level versus inflation targeting with financial market imperfections," Canadian Journal of Economics, Canadian Economics Association, vol. 43(4), pages 1302-1332, November.
  8. Ben S. Bernanke & Vincent Reinhart & Brian P. Sack, 2004. "Monetary policy alternatives at the zero bound: an empirical assessment," Finance and Economics Discussion Series 2004-48, Board of Governors of the Federal Reserve System (U.S.).
  9. Yates, Tony, 2002. "Monetary policy and the zero bound to interest rates: a review," Working Paper Series 0190, European Central Bank.
  10. Marvin Goodfriend, 2000. "Overcoming the zero bound on interest rate policy," Working Paper 00-03, Federal Reserve Bank of Richmond.
  11. Bernanke, Ben & Gertler, Mark, 1995. "Inside the Black Box: The Credit Channel of Monetary Policy Transmission," Working Papers 95-15, C.V. Starr Center for Applied Economics, New York University.
  12. Ian Christensen & Ali Dib, 2006. "Monetary Policy in an Estimated DSGE Model with a Financial Accelerator," Staff Working Papers 06-9, Bank of Canada.
  13. Corsetti, Giancarlo & Kuester, Keith & Meier, André & Müller, Gernot, 2010. "Debt consolidation and fiscal stabilization of deep recessions," CEPR Discussion Papers 7649, C.E.P.R. Discussion Papers.
  14. Bodenstein, Martin & Erceg, Christopher & Guerrieri, Luca, 2010. "The Effects of Foreign Shocks When Interest Rates Are at Zero," CEPR Discussion Papers 8006, C.E.P.R. Discussion Papers.
  15. David L. Reifschneider & John C. Williams, 2000. "Three lessons for monetary policy in a low-inflation era," Conference Series ; [Proceedings], Federal Reserve Bank of Boston, pages 936-978.
  16. Bernanke, Ben S. & Gertler, Mark & Gilchrist, Simon, 1999. "The financial accelerator in a quantitative business cycle framework," Handbook of Macroeconomics, in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 21, pages 1341-1393 Elsevier.
  17. Michael Woodford, 2011. "Simple Analytics of the Government Expenditure Multiplier," American Economic Journal: Macroeconomics, American Economic Association, vol. 3(1), pages 1-35, January.
  18. Willem H. Buiter & Nikolaos Panigirtzoglou, 1999. "Liquidity Traps: How to Avoid Them and How to Escape Them," NBER Working Papers 7245, National Bureau of Economic Research, Inc.
  19. Lawrence Christiano & Martin Eichenbaum & Sergio Rebelo, 2009. "When is the government spending multiplier large?," NBER Working Papers 15394, National Bureau of Economic Research, Inc.
  20. Corsetti, Giancarlo & Meier, André & Müller, Gernot, 2009. "Fiscal Stimulus with spending reversals," CEPR Discussion Papers 7302, C.E.P.R. Discussion Papers.
  21. Robert Amano & Malik Shukayev, 2012. "Risk Premium Shocks and the Zero Bound on Nominal Interest Rates," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 44(8), pages 1475-1505, December.
  22. Jesper Linde & Christopher J. Erceg, 2010. "Is There a Fiscal Free Lunch in a Liquidity Trap?," 2010 Meeting Papers 380, Society for Economic Dynamics.
  23. Gauti B. Eggertsson & Michael Woodford, 2003. "Optimal Monetary Policy in a Liquidity Trap," NBER Working Papers 9968, National Bureau of Economic Research, Inc.
  24. Bernanke, Ben & Gertler, Mark, 1989. "Agency Costs, Net Worth, and Business Fluctuations," American Economic Review, American Economic Association, vol. 79(1), pages 14-31, March.
  25. Smets, Frank, 2000. "What horizon for price stability," Working Paper Series 0024, European Central Bank.
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