Discretionary Monetary Policy and the Zero Lower Bound on Nominal Interest Rates

41 Pages Posted: 3 Jan 2006

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 2 versions of this paper

Abstract

Ignoring the existence of the zero lower bound on nominal interest rates one considerably understates the value of monetary commitment in New Keynesian models. A stochastic forward-looking model with an occasionally binding lower bound, calibrated to the U.S. economy, suggests that low values for the natural rate of interest lead to sizeable output losses and deflation under discretionary monetary policy. The fall in output and deflation are much larger than in the case with policy commitment and do not show up at all if the model abstracts from the existence of the lower bound. The welfare losses of discretionary policy increase even further when inflation is partly determined by lagged inflation in the Phillips curve. These results emerge because private sector expectations and the discretionary policy response to these expectations reinforce each other and cause the lower bound to be reached much earlier than under commitment.

Keywords: nonlinear optimal policy, occasionally binding constraint, sequential policy, Markov perfect equilibrium, liquidity trap

JEL Classification: E31, E52

Suggested Citation

Adam, Klaus and Billi, Roberto M., Discretionary Monetary Policy and the Zero Lower Bound on Nominal Interest Rates. Journal of Monetary Economics, Forthcoming, Available at SSRN: https://ssrn.com/abstract=873464

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