Working Paper: CEPR ID: DP5997
Authors: Doug Laxton; Papa Ndiaye; Paolo Pesenti
Abstract: The paper considers the macroeconomic transmission of demand and supply shocks in an open economy under alternative assumptions on whether the zero interest floor (ZIF) is binding. It uses a two-country general-equilibrium simulation model calibrated to the Japanese economy vis-à-vis the rest of the world. Negative demand shocks have more prolonged and startling effects on the economy when the ZIF is binding than when it is not binding. Positive supply shocks can actually extend the period of time over which the ZIF may be expected to bind. More open economies hit the ZIF for a shorter period of time, and with less harmful effects. Deflationary supply shocks have different implications according to whether they are concentrated in the tradables rather than the nontradables sector. Price-level-path targeting rules are likely to provide better guidelines for monetary policy in a deflationary environment, and have desirable properties in normal times when the ZIF is not binding.
Keywords: deflation; monetary policy rules; zero interest rate floor
JEL Codes: E17; E52; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Negative demand shocks (E31) | More pronounced and prolonged adverse effects on the economy when ZIF is binding (F69) |
| Positive supply shocks (E65) | Extend the binding period of the ZIF (Y20) |
| Positive supply shocks (E65) | Increase vulnerability to subsequent adverse demand shocks (E32) |
| Effectiveness of price-level path targeting rules (E61) | Superior to traditional inflation-targeting rules under binding ZIF (E31) |
| Openness in the economy (F41) | Reduce duration and severity of adverse effects associated with binding ZIF (C41) |
| Openness in the economy (F41) | Better withstand negative demand shocks (E32) |