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Implications of the Zero Bound on Interest Rates for the Design of Monetary Policy Rules


  • David Reifschneider

    () (Board of Governors of the Federal Reserve System)

  • John C. Williams

    () (Board of Governors of the Federal Reserve System)


In the presence of nominal rigidities, monetary policy can potentially improve welfare by reducing the magnitude of short-run fluctuations in inflation and resource utilization. According to a standard view of the monetary transmission mechanism, monetary policy stimulates economic activity by reducing the short-term real rate of interest. The zero lower bound on nominal interest rates, however, can constrain the ability to lower real rates. In this paper, we use the FRB/US macroeconometric model to quantify the effects of the zero bound on macroeconomic stabilization and to explore formulations of policy that minimize these effects. We draw three broad conclusions from this research. First, during particularly severe contractions, monetary policy alone is insufficient to restore macroeconomic equilibrium; fiscal policy or some other autonomous stimulus is also needed. Second, the one-sided nature of the zero bound implies that a standard linear policy rule, such as the Taylor rule, yields an upward bias to interest rates and hence a downward bias in the rate of inflation. We find that this bias can be easily overcome by introducing an offsetting downward adjustment to the policy rule. Finally, in a low-inflation environment, where policy follows a Taylor rule, the constraint on policy from the zero bound leads to a significant increase in the volatility of resource utilization and, to a lesser extent, inflation. Augmenting the Taylor rule to incorporate a response to past and expected future constraints on policy dramatically reduces the detrimental effects of the zero bound. Interestingly, policy rules that are efficient in the absence of the zero bound, implicitly incorporate such behavior; hence, for such rules, the zero bound generates only relatively small stabilization costs.

Suggested Citation

  • David Reifschneider & John C. Williams, 1999. "Implications of the Zero Bound on Interest Rates for the Design of Monetary Policy Rules," Computing in Economics and Finance 1999 843, Society for Computational Economics.
  • Handle: RePEc:sce:scecf9:843

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    References listed on IDEAS

    1. Froyen, Richard T. & Waud, Roger N., 1995. "Central bank independence and the output-inflation tradeoff," Journal of Economics and Business, Elsevier, vol. 47(2), pages 137-149, May.
    2. Barro, Robert J. & Gordon, David B., 1983. "Rules, discretion and reputation in a model of monetary policy," Journal of Monetary Economics, Elsevier, vol. 12(1), pages 101-121.
    3. Andreas Fischer, 1996. "Central bank independence and sacrifice ratios," Open Economies Review, Springer, vol. 7(1), pages 5-18, January.
    4. Adam S. Posen, 1995. "Declarations Are Not Enough: Financial Sector Sources of Central Bank Independence," NBER Chapters,in: NBER Macroeconomics Annual 1995, Volume 10, pages 253-274 National Bureau of Economic Research, Inc.
    5. Clive Briault & Andrew Haldane & Mervyn King, 1996. "Independence and Accountability," Bank of England working papers 49, Bank of England.
    6. Bean, Charles, 1998. "The New UK Monetary Arrangements: A View from the Literature," Economic Journal, Royal Economic Society, vol. 108(451), pages 1795-1809, November.
    7. Julia Darby & Simon Wren-Lewis, 1993. "Is There a Cointegrating Vector for UK Wages?," Journal of Economic Studies, Emerald Group Publishing, vol. 20(1/2), pages 87-115, January.
    8. Walsh, Carl E, 1995. "Optimal Contracts for Central Bankers," American Economic Review, American Economic Association, vol. 85(1), pages 150-167, March.
    9. repec:sae:niesru:v:161:y::i:1:p:91-110 is not listed on IDEAS
    10. Kydland, Finn E & Prescott, Edward C, 1977. "Rules Rather Than Discretion: The Inconsistency of Optimal Plans," Journal of Political Economy, University of Chicago Press, vol. 85(3), pages 473-491, June.
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    Cited by:

    1. Ortiz, Marco, 2015. "Choques de colas anchas y política monetaria," Revista Estudios Económicos, Banco Central de Reserva del Perú, issue 29, pages 17-31.
    2. Keith Kuester & Volker Wieland, 2010. "Insurance Policies for Monetary Policy in the Euro Area," Journal of the European Economic Association, MIT Press, vol. 8(4), pages 872-912, June.

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