Working Paper: CEPR ID: DP16403
Authors: Günter Coenen; Carlos Montes-Galdón; Sebastian Schmidt
Abstract: The secular decline in the equilibrium real interest rate observed over the past decades has materially limited the room for policy-rate reductions in recessions, and has led to a marked increase in the incidence of episodes where policy rates are likely to be at, or near, the effective lower bound on nominal interest rates. Using the ECB's New Area-Wide Model, we show that, if unaddressed, the effective lower bound can cause substantial costs in terms of worsened macroeconomic performance, as reflected in negative biases in inflation and economic activity, as well as heightened macroeconomic volatility. These costs can be mitigated by the use of nonstandard instruments, notably the joint use of interest-rate forward guidance and large-scale asset purchases. When considering alternatives to inflation targeting, we find that make-up strategies such as price-level targeting and average-inflation targeting can, if they are well-understood by the private sector, largely undo the negative biases and heightened volatility induced by the effective lower bound.
Keywords: effective lower bound; monetary policy; asset purchases; forward guidance; makeup strategies
JEL Codes: E31; E32; E37; E52; E58
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| effective lower bound (ELB) (C51) | negative biases in inflation (E31) |
| effective lower bound (ELB) (C51) | negative biases in output gaps (E24) |
| effective lower bound (ELB) (C51) | increased macroeconomic volatility (E32) |
| nonstandard monetary policy instruments (E52) | mitigate negative effects of ELB (F69) |
| forward guidance + asset purchases (E52) | reduce negative inflation bias (E31) |
| forward guidance + asset purchases (E52) | decrease inflation volatility (E31) |
| makeup strategies (C78) | undo negative biases induced by ELB (D91) |
| makeup strategies (C78) | improve macroeconomic stabilization outcomes (E63) |