Working Paper: CEPR ID: DP4585
Authors: Klaus Adam; Roberto M. Billi
Abstract: We determine optimal discretionary monetary policy in a New Keynesian model when nominal interest rates are bounded below by zero. Nominal interest rates should be lowered faster in response to adverse shocks than in the case without bound. Such ?pre-emptive easing? is optimal because expectations of a possibly binding bound in the future amplify the effects of adverse shocks. Calibrating the model to the US economy we find the easing effect to be quantitatively important. Moreover, the lower bound binds rather frequently and imposes significant welfare losses. Losses increase further when inflation is partly determined by lagged inflation in the Phillips curve. Targeting positive inflation rates reduces the frequency of a binding lower bound, but tends to reduce welfare compared to a target rate of zero. The welfare gains from policy commitment, however, appear significant and are much larger than in the case without lower bound.
Keywords: liquidity trap; nonlinear policy; zero lower 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 |
|---|---|
| adverse shocks (E32) | necessity for aggressive monetary policy easing (E63) |
| expectations of future binding ZLB conditions (E66) | amplification of effects of adverse shocks (E71) |
| inflation influenced by lagged inflation (E31) | exacerbation of welfare losses (D69) |
| targeting positive inflation rates (E52) | reduction in frequency of encountering ZLB (E31) |
| targeting positive inflation rates (E52) | diminishment of welfare relative to zero inflation target (D69) |
| policy commitment (E60) | improved welfare outcomes (I38) |