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

Klaus Adam () and Roberto Billi

No 2005/16, CFS Working Paper Series from Center for Financial Studies (CFS)

Abstract: 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 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.

Keywords: Nonlinear Optimal Policy; Occasionally Binding Constraint; Sequential Policy; Markov Perfect Equilibrium; Liquidity Trap (search for similar items in EconPapers)
JEL-codes: E31 E52 (search for similar items in EconPapers)
Date: 2005
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Related works:
Journal Article: Discretionary monetary policy and the zero lower bound on nominal interest rates (2007) Downloads
Working Paper: Discretionary monetary policy and the zero lower bound on nominal interest rates (2005) Downloads
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