Working Paper: CEPR ID: DP2314
Authors: Jess Benhabib; Stephanie Schmitt-Groh; Martin Uribe
Abstract: Since John Taylor's (1993) seminal paper, a large literature has argued that active interest rate feedback rules, that is, rules that respond to increases in inflation with a more than one-for-one increase in the nominal interest rate, are stabilizing. In this paper, we argue that once the zero bound on nominal interest rates is taken into account, active interest rate feedback rules can easily lead to unexpected consequences. Specifically, we show that even if the steady state at which monetary policy is active, is locally the unique equilibrium, typically there exists an infinite number of equilibrium trajectories originating arbitrarily close to that steady state, that converge to a liquidity trap, that is, a steady state in which the nominal interest rate is near zero and inflation is possibly negative.
Keywords: interest rate feedback rules; liquidity trap; zero bound on nominal interest rates
JEL Codes: E31; E52; E63
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| active monetary policy (E63) | dynamics of liquidity traps (E41) |
| constraints of monetary policy (E52) | emergence of liquidity traps (E41) |
| active interest rate feedback rules (E43) | unexpected consequences (F69) |
| zero lower bound on nominal interest rates (E43) | low-inflation equilibrium (E31) |
| central bank's inability to lower nominal rates (E49) | liquidity traps (E41) |
| self-fulfilling expectations (D84) | liquidity traps (E41) |