Monetary Policy and the Drifting Natural Rate of Interest

Sandra Daudignon and Oreste Tristani

No 19528, CEPR Discussion Papers from Centre for Economic Policy Research

Abstract: Empirical analyses find that the long-run natural rate, or the real rate prevailing over a long-run equilibrium where nominal rigidities are absent, is subject to permanent shocks. How should monetary policy react to such shocks? Our paper answers this question in a variant of the new Keynesian model. Because of the zero lower bound (ZLB) on nominal interest rates, the mere possibility of future movements towards zero of the long-run natural rate imparts a downward bias on inflation expectations. To offset this bias, a central bank optimizing under commitment should not only rely on forward guidance at the ZLB, as recommended by the existing literature, but also adopt an expansionary bias away from the ZLB. The neutral rate, i.e. the real policy rate consistent with stable inflation in the long-run, should fall more than one-to-one with the long-run natural rate, as the latter approaches zero. This is the case both under optimal commitment policy, and if optimal policy is implemented through a price level targeting rule.

Keywords: Zero lower bound; Optimal monetary policy with commitment; Liquidity trap; New keynesian model (search for similar items in EconPapers)
JEL-codes: C63 E31 E52 (search for similar items in EconPapers)
Date: 2024-09
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