Gradualism and Liquidity Traps

30 Pages Posted: 21 Nov 2016

See all articles by Taisuke Nakata

Taisuke Nakata

Board of Governors of the Federal Reserve System

Sebastian Schmidt

European Central Bank (ECB)

Multiple version iconThere are 2 versions of this paper

Date Written: 2016-11

Abstract

Modifying the objective function of a discretionary central bank to include an interest-rate smoothing objective increases the welfare of an economy in which large contractionary shocks occasionally force the central bank to lower the policy rate to its effective lower bound. The central bank with an interest-rate smoothing objective credibly keeps the policy rate low for longer than the central bank with the standard objective function. Through expectations, the temporary overheating of the economy associated with such a low-for-long interest rate policy mitigates the declines in inflation and output when the lower bound constraint is binding. In a calibrated model, we find that the introduction of an interest-rate smoothing objective can reduce the welfare costs associated with the lower bound constraint by more than one-half.

Keywords: Gradualism, Inflation Targeting, Interest-Rate Smoothing, Liquidity Traps, Zero Lower Bound

JEL Classification: E52, E61

Suggested Citation

Nakata, Taisuke and Schmidt, Sebastian, Gradualism and Liquidity Traps (2016-11). FEDS Working Paper No. 2016-092. Available at SSRN: https://ssrn.com/abstract=2872650 or http://dx.doi.org/10.17016/FEDS.2016.092

Taisuke Nakata (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Sebastian Schmidt

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

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