Discretionary monetary policy and the zero lower bound on nominal interest rates

• Published in: Journal of monetary economics Vol. 54; no. 3; pp. 728 - 752
• Main Authors: Adam, Klaus, Billi, Roberto M.
• Format: Journal Article
• Language: English
• Published: Amsterdam Elsevier B.V 01-04-2007; Elsevier; Elsevier Sequoia S.A
• Series: Journal of Monetary Economics
• Subjects: Deflation; Equilibrium; Inflation; Interest rates; Keynesian theory; Liquidity trap; Markov perfect equilibrium; Monetary policy; Non-linear models; Nonlinear optimal policy; Occasionally binding constraint; Phillips curve; Sequential policy; Stochastic models; Studies; U.S.A; United States > US; Markov perfect equilibrium; E31; E52; Nonlinear optimal policy; Occasionally binding constraint; Liquidity trap; Sequential policy
• ISSN: 0304-3932; 1873-1295
• DOI: 10.1016/j.jmoneco.2005.11.003

Ignoring the existence of the zero lower bound on nominal interest rates one considerably understates the value of monetary commitment in New Keynesian models. A stochastic forward-looking model with an occasionally binding lower bound, calibrated to the U.S. economy, suggests that low values for the natural rate of interest lead to sizeable output losses and deflation under discretionary monetary policy. The fall in output and deflation are much larger than in the case with policy commitment and do not show up at all if the model abstracts from the existence of the lower bound. The welfare losses of discretionary policy increase even further when inflation is partly determined by lagged inflation in the Phillips curve. These results emerge because private sector expectations and the discretionary policy response to these expectations reinforce each other and cause the lower bound to be reached much earlier than under commitment.