An Interest Rate Rule to Uniquely Implement the Optimal Equilibrium in a Liquidity Trap

41 Pages Posted: 7 Sep 2017

See all articles by Fernando Duarte

Fernando Duarte

Federal Reserve Bank of New York

Anna Zabai

Bank for International Settlements (BIS)

Date Written: 2015-10-01

Abstract

We propose a new interest rate rule that implements the optimal equilibrium and eliminates all indeterminacy in a canonical New Keynesian model in which the zero lower bound on nominal interest rates (ZLB) is binding. The rule commits to zero nominal interest rates for a length of time that increases in proportion to how much past inflation has deviated—either upward or downward—from its optimal level. Once outside the ZLB, interest rates follow a standard Taylor rule. Following the Taylor principle outside the ZLB is neither necessary nor sufficient to ensure uniqueness of equilibria. Instead, the key principle is to respond strongly enough to deviations of past inflation from optimal levels by sufficiently increasing the amount of time interest rates are promised to be kept at zero.

Keywords: zero lower bound, ZLB, liquidity trap, New Keynesian model, indeterminacy, monetary policy, Taylor rule, Taylor principle, interest rate rule, forward guidance

JEL Classification: E43, E52, E58

Suggested Citation

Duarte, Fernando and Zabai, Anna, An Interest Rate Rule to Uniquely Implement the Optimal Equilibrium in a Liquidity Trap (2015-10-01). FRB of New York Economics and Finance Paper No. 745, Available at SSRN: https://ssrn.com/abstract=3029752

Fernando Duarte (Contact Author)

Federal Reserve Bank of New York ( email )

33 Liberty Street
New York, NY 10045
United States

HOME PAGE: http://www.newyorkfed.org/research/economists/duarte/index.html

Anna Zabai

Bank for International Settlements (BIS) ( email )

Centralbahnplatz 2
Basel, Basel-Stadt 4002
Switzerland

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