(Un)Conventional Policy and the Effective Lower Bound

Abstract

We study the optimal combination of interest rate policy and unconventional monetary policy in a model where agency costs generate a spread between deposit and lending rates. We show that credit policy can be a powerful substitute for interest rate policy. In the face of shocks that negatively affect banks' monitoring efficiency, unconventional measures insulate the real economy from further deterioration in financial conditions and it may be optimal for the central bank not to cut rates to zero. Thus, credit policy lowers the likelihood of hitting the zero bound constraint. Reductions in the policy rates without non-standard measures are suboptimal as they inefficiently force savers to change their intertemporal consumption patterns.

Keywords: optimal monetary policy, unconventional policies, zero-lower bound, asymmetric information

JEL Classification: E44, E52, E61