Optimal Monetary Policy Under Commitment with a Zero Bound on Nominal Interest Rates

36 Pages Posted: 18 Dec 2003

See all articles by Klaus Adam

Klaus Adam

University of Mannheim; European Central Bank (ECB) - Department of Research; Centre for Economic Policy Research (CEPR)

Roberto M. Billi

Sveriges Riksbank

Multiple version iconThere are 4 versions of this paper

Date Written: November 2003

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: Non-linear optimal policy, zero interest rate bound, commitment, liquidity trap, new Keynesian

JEL Classification: C63, E31, E52

Suggested Citation

Adam, Klaus and Billi, Roberto M., Optimal Monetary Policy Under Commitment with a Zero Bound on Nominal Interest Rates (November 2003). Available at SSRN: https://ssrn.com/abstract=480662

Klaus Adam (Contact Author)

University of Mannheim ( email )

Department of Economics
L7 ,3-5
Mannheim, 68131
Germany

HOME PAGE: http://adam.vwl.uni-mannheim.de/1528.0.html

European Central Bank (ECB) - Department of Research ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany
+49 69 1344 6597 (Phone)

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Roberto M. Billi

Sveriges Riksbank ( email )

Brunkebergstorg 11
SE-103 37 Stockholm
Sweden

HOME PAGE: http://www.rmbilli.com