Monetary Policy Rules and the Effective Lower Bound in the Euro Area

33 Pages Posted: 9 Apr 2021 Last revised: 18 Nov 2021

See all articles by Markus Haavio

Markus Haavio

Bank of Finland - Research

Olli-Matti Laine

Bank of Finland

Date Written: April 8, 2021

Abstract

We analyze the economic performance of different monetary policy strategies, or rules, in a low interest rate environment, using simulations with a DSGE model which has been estimated for the euro area. We study how often the effective lower bound of interest rates (ELB) is likely to bind, and how much forgone monetary policy accommodation this entails. Macroeconomic outcomes are measured by the mean levels and the volatility of output (gaps), unemployment and inflation. We present three sets of results. First, the macroeconomic costs of the ELB are likely to grow in a non-linear manner if the monetary policy space (the difference between the normal, or average, level of nominal interest rates and the ELB) shrinks. Second, a point inflation target appears to outperform a target range. Third, the (relative) performance of low-for-long (L4L) monetary policy rules depends on the size of the monetary policy space. The L4L rules tend to perform well, if the monetary space is small, but if the space is larger these rules, while stabilizing inflation, may lead to more volatility in the real economy than flexible inflation targeting.

JEL Classification: E31, E32, E52, E58

Suggested Citation

Haavio, Markus and Laine, Olli-Matti, Monetary Policy Rules and the Effective Lower Bound in the Euro Area (April 8, 2021). Bank of Finland Research Discussion Paper No. 5/2021, Available at SSRN: https://ssrn.com/abstract=3822898 or http://dx.doi.org/10.2139/ssrn.3822898

Markus Haavio (Contact Author)

Bank of Finland - Research ( email )

P.O. Box 160
FIN-00101 Helsinki
Finland

Olli-Matti Laine

Bank of Finland ( email )

P.O. Box 160
Helsinki 00101
Finland

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