Working Paper: NBER ID: w27878
Authors: Gauti B. Eggertsson; Sergey K. Egiev; Alessandro Lin; Josef Platzer; Luca Riva
Abstract: This paper presents a toolkit to solve for equilibrium in economies with the effective lower bound (ELB) on the nominal interest rate in a computationally efficient way under a special assumption about the underlying shock process, a two-state Markov process with an absorbing state. We illustrate the algorithm in the canonical New Keynesian model, replicating the optimal monetary policy in Eggertsson and Woodford (2003), as well as showing how the toolkit can be used to analyse the medium-scale DSGE model developed by the Federal Reserve Bank of New York. As an application, we show how various policy rules perform relative to the optimal commitment equilibrium. A key conclusion is that previously suggested policy rules – such as price level targeting and nominal GDP targeting – do not perform well when there is a small drop in the price level, as observed during the Great Recession, because they do not imply sufficiently strong commitment to low future interest rates (“make-up strategy”). We propose two new policy rules, Cumulative Nominal GDP Targeting Rule and Symmetric Dual-Objective Targeting Rule that are more robust. Had these policies been in place in 2008, they would have reduced the output contraction by approximately 80 percent. If the Federal Reserve had followed Average Inflation Targeting – which can arguably approximate the new policy framework announced in August 2020 – the output contraction would have been roughly 25 percent smaller.
Keywords: Effective Lower Bound; Monetary Policy; Dynamic Stochastic General Equilibrium; Cumulative Nominal GDP Targeting; Symmetric Dual-Objective Targeting
JEL Codes: E31; E40; E50; E60
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| policy rules (E61) | output contraction (E32) |
| cumulative nominal GDP targeting rule (E19) | output contraction (E32) |
| symmetric dual-objective targeting rule (L21) | output contraction (E32) |
| average inflation targeting (E31) | output contraction (E32) |
| expectations about future economic conditions (E66) | effectiveness of policy rules (E61) |