Optimal and Simple Monetary Policy Rules with Zero Floor on the Nominal Interest Rate

52 Pages Posted: 20 Sep 2005

See all articles by Anton Nakov

Anton Nakov

European Central Bank (ECB); CEPR

Date Written: September 4, 2005

Abstract

Recent treatments of the issue of a zero floor on nominal interest rates have been subject to some important methodological limitations. These include the assumption of perfect foresight or the introduction of the zero lower bound as an initial condition or a constraint on the variance of the interest rate, rather than an occasionally binding non-negativity constraint. This paper addresses these issues offering a global solution to a standard dynamic stochastic sticky price model with an explicit occasionally binding non-negativity constraint on the nominal interest rate. It turns out that the dynamics and sometimes the unconditional means of the nominal rate, inflation and the output gap are strongly affected by uncertainty in the presence of the zero lower bound. Commitment to the optimal rule reduces unconditional welfare losses to around one-tenth of those achievable under discretionary policy, while constant price level targeting delivers losses which are only 60% larger than under the optimal rule. Even though the unconditional performance of simple instrument rules is almost unaffected by the presence of the zero lower bound, conditional on a strong deflationary shock simple instrument rules perform substantially worse than the optimal policy.

Keywords: liquidity trap, zero lower bound, optimal monetary policy, simple rules, monetary policy, zero floor, nominal interest rates

JEL Classification: E31, E32, E37, E52

Suggested Citation

Nakov, Anton A., Optimal and Simple Monetary Policy Rules with Zero Floor on the Nominal Interest Rate (September 4, 2005). Banco de España Research Paper No. WP-0637, Available at SSRN: https://ssrn.com/abstract=804785 or http://dx.doi.org/10.2139/ssrn.804785

Anton A. Nakov (Contact Author)

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

CEPR ( email )

London
United Kingdom

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