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Gradualism and Liquidity Traps

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  • Schmidt, Sebastian
  • Nakata, Taisuke

Abstract

Modifying the mandate of a discretionary central bank to include an interest-rate smoothing objective increases the welfare of an economy where large contractionary shocks occasionally force the central bank to lower the policy rate to its effective lower bound. The central bank with an interest-rate smoothing objective credibly keeps the policy rate low for longer than the discretionary central bank with the standard mandate does, as in optimal commitment policy. Through expectations, the temporary overheating of the economy associated with such low-for-long interest rate policy mitigates the declines in inflation and output when the lower bound constraint is binding. In a calibrated model, we find that the introduction of an interest-rate smoothing objective can reduce the welfare costs associated with the lower bound constraint by more than half.

Suggested Citation

  • Schmidt, Sebastian & Nakata, Taisuke, 2016. "Gradualism and Liquidity Traps," Annual Conference 2016 (Augsburg): Demographic Change 145469, Verein für Socialpolitik / German Economic Association.
  • Handle: RePEc:zbw:vfsc16:145469
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    References listed on IDEAS

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    Cited by:

    1. Galí, Jordi, 2018. "The State of New Keynesian Economics: A Partial Assessment," CEPR Discussion Papers 13095, C.E.P.R. Discussion Papers.
    2. Jordi Galí, 2018. "The State of New Keynesian Economics: A Partial Assessment," NBER Working Papers 24845, National Bureau of Economic Research, Inc.
    3. Mertens, Thomas M. & Williams, John C., 2019. "Monetary policy frameworks and the effective lower bound on interest rates," Staff Reports 877, Federal Reserve Bank of New York, revised 13 Jan 2019.
    4. Nakata, Taisuke & Schmidt, Sebastian, 2019. "Conservatism and liquidity traps," Journal of Monetary Economics, Elsevier, vol. 104(C), pages 37-47.
    5. Kohei Hasui & Teruyoshi Kobayashi & Tomohiro Sugo, 2019. "Irreversible monetary policy at the zero lower bound," Discussion Papers 1906, Graduate School of Economics, Kobe University.
    6. repec:ecb:ecbrbu:2018:0045: is not listed on IDEAS
    7. Mertens, Thomas M. & Williams, John C., 2019. "Tying Down the Anchor: Monetary Policy Rules and the Lower Bound on Interest Rates," Working Paper Series 2019-14, Federal Reserve Bank of San Francisco.

    More about this item

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies

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