Monetary policy in a low inflation economy with learning

John Williams

Economic Review, 2010, 1-12

Abstract: In theory, monetary policies that target the price level, as opposed to the inflation rate, should be highly effective at stabilizing the economy and avoiding deflation in the presence of the zero lower bound on nominal interest rates. With such a policy, if the short-term interest rate is constrained at zero and the inflation rate declines below its trend, the public expects that policy will eventually engineer a period of above-trend inflation that restores the price level to its target level. Expectations of future monetary accommodation stimulate output and inflation today, mitigating the effects of the zero bound. The effectiveness of such a policy strategy depends crucially on the alignment of the publics and the central banks expectations of future policy actions. ; This article considers an environment where private agents have imperfect knowledge of the economy and therefore continuously reestimate the forecasting model that they use to form expectations. I find that imperfect knowledge on the part of the public, especially regarding monetary policy, can undermine the effectiveness of price-level targeting strategies that would work well if the public had complete knowledge. For low inflation targets, the zero lower bound can cause a dramatic deterioration in macroeconomic performance with severe recessions occurring with alarming frequency. However, effective communication of the policy strategy that reduces the publics confusion about the future course of monetary policy significantly reduces the stabilization costs associated with the zero bound. Finally, the combination of learning and the zero bound implies the need for a stronger policy response to movements in the price level than would otherwise be optimal. Such a policy is effective at stabilizing both inflation and output in the presence of learning and the zero bound even with a low inflation target.

Keywords: Monetary policy; Inflation (Finance) (search for similar items in EconPapers)
Date: 2010
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (24)

Downloads: (external link)
https://www.frbsf.org/wp-content/uploads/er1-12.pdf Full Text (text/html)

Related works:
Working Paper: Monetary policy in a low inflation economy with learning (2006)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:fip:fedfer:y:2010:p:1-12

Ordering information: This journal article can be ordered from

Access Statistics for this article

More articles in Economic Review from Federal Reserve Bank of San Francisco Contact information at EDIRC.
Bibliographic data for series maintained by Federal Reserve Bank of San Francisco Research Library ().