Working Paper: CEPR ID: DP4111
Authors: Klaus Adam; Roberto M. Billi
Abstract: We compute the optimal non-linear interest rate policy under commitment for a forward-looking stochastic model with monopolistic competition and sticky prices when nominal interest rates are bounded below by zero. When the lower bound binds, the optimal policy is to reduce the real rate by generating inflation expectations. This is achieved by committing to increase future interest rates by less than what purely forward-looking policy would suggest. As a result, there is a ?commitment bias?, i.e., average output and inflation turn out to be higher than their target values. Calibrating the model to the US economy we find that the quantitative importance of the average effects on output and inflation are negligible. Moreover, the empirical magnitude of US mark-up shocks is too small to entail zero nominal interest rates. Real rate shocks, however, plausibly lead to a binding lower bound under optimal policy, albeit relatively infrequently. Interestingly, the presence of binding real rate shocks alters the optimal policy response to (non-binding) mark-up shocks.
Keywords: commitment; liquidity trap; new keynesian; nonlinear optimal policy; zero interest rate bound
JEL Codes: C63; E31; E52
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| binding lower bound (C69) | inflation expectations (E31) |
| nominal interest rates bound by zero (E43) | optimal policy generates inflation expectations (E31) |
| optimal policy (C61) | higher average output and inflation (E31) |
| real rate shocks (E43) | binding lower bound (C69) |
| binding lower bound (C69) | increase inflation and output gaps (E31) |
| binding real rate shocks (E43) | alters policy response to non-binding markup shocks (C54) |
| zero lower bound (E49) | positive average inflation rates (E31) |