Optimal Monetary Policy at the Zero Lower Bound on Nominal Interest Rates in a Cost Channel Economy

The nominal interest rates were at zero level in the recent past in many countries across the globe. It has been widely debated recently what a central bank should do to stimulate the economy when the nominal interest rate is at the zero lower bound (ZLB). The optimal monetary policy literature suggests that monetary policy inertia, i.e. committing to continue zero interest regime even after the ZLB is not binding, is a way to get the economy out of recession. In this paper, I examine whether this result holds when monetary policy has not only the conventional demand-side effect but also a supply-side effect on the economy. To accomplish this objective, I incorporate the cost channel of monetary policy into an otherwise standard new Keynesian model and evaluate the optimal monetary policy at the ZLB. The study revealed some important insights in the conduct of the optimal monetary policy in a cost channel economy at the ZLB. First, the discretionary policy requires central banks to keep interest rates at the zero lower bound for longer in a cost channel economy compared to no-cost channel economies. This is because, in cost channel economies, the deflation is high and persistent due to a larger negative demand shock than that found in no-cost channel economies. Further, cost channel economies introduce a policy trade-off between inflation and output gap. Under commitment policy, the simulation exercise shows that the central bank is able to terminate the zero interest rate regime earlier in a cost channel economy than otherwise. The reason for that is, in a cost channel economy, the private sector has inflated inflationary expectations when the central bank is planning to conduct a tight monetary policy. This result is in contrast to the results found under discretionary policy. It was also revealed that the cost channel generates substantially high welfare losses, under both discretionary and commitment policies. Accordingly, abstracting the cost channel in these types of models can lead to under estimation of welfare losses.