Monetary Policy Frameworks and the Effective Lower Bound on Interest Rates

15 Pages Posted: 7 Jul 2019

See all articles by Thomas M. Mertens

Thomas M. Mertens

Federal Reserve Bank of San Francisco

John C. Williams

Federal Reserve Bank of New York

Date Written: January 2019

Abstract

This paper applies a standard New Keynesian model to analyze the effects of monetary policy in the presence of a low natural rate of interest and a lower bound on interest rates. Under a standard inflation-targeting approach, inflation expectations will be anchored at a level below the inflation target, which in turn exacerbates the deleterious effects of the lower bound on the economy. Two key themes emerge from our analysis. First, the central bank can mitigate this problem of a downward bias in inflation expectations by following an average-inflation targeting framework that aims for above-target inflation during periods when policy is unconstrained. Second, a dynamic strategy such as price-level targeting that raises inflation expectations when inflation is low can both anchor expectations at the target level and potentially further reduce the effects of the lower bound on the economy.

Keywords: monetary policy, zero lower bound, natural rate of interest, inflation targeting, inflation expectations

JEL Classification: E52

Suggested Citation

Mertens, Thomas M. and Williams, John C., Monetary Policy Frameworks and the Effective Lower Bound on Interest Rates (January 2019). FRB of New York Staff Report No. 877, Available at SSRN: https://ssrn.com/abstract=3413950 or http://dx.doi.org/10.2139/ssrn.3413950

Thomas M. Mertens (Contact Author)

Federal Reserve Bank of San Francisco ( email )

101 Market Street
San Francisco, CA 94105
United States

John C. Williams

Federal Reserve Bank of New York ( email )

33 Liberty Street
New York, NY 10045
United States

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