Monetary policy inertia and the paradox of flexibility

Dario Bonciani and Joonseok Oh

Journal of Economic Dynamics and Control, 2023, vol. 151, issue C

Abstract: This paper revisits the paradox of flexibility, i.e., the result that, in a liquidity trap, greater price flexibility amplifies output volatility in response to negative demand shocks. We argue this paradox is the consequence of a failure of standard models to correctly characterise monetary policy at the zero lower bound. We show that allowing for a smooth adjustment of the shadow policy rate eliminates the paradox and produces output responses to a negative demand shock that are in line with those under optimal monetary policy. The reason is that, under an inertial policy, a decline in the shadow rate implies that the future actual policy rate will remain relatively low, which increases expectations about the economic outlook and inflation. The rise in inflation expectations reduces the real rate, thereby sustaining real activity. As we raise the degree of price flexibility, a negative demand shock causes a sharper fall in the shadow rate and increase in inflation expectations, which leads to a more significant drop in the real rate and, hence, a milder decline in the output gap.

Keywords: Interest rate smoothing; Liquidity trap; Zero lower bound; Paradox of flexibility (search for similar items in EconPapers)
JEL-codes: E32 E52 E61 (search for similar items in EconPapers)
Date: 2023
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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Working Paper: Monetary policy inertia and the paradox of flexibility (2020)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:dyncon:v:151:y:2023:i:c:s016518892300074x

DOI: 10.1016/j.jedc.2023.104668

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