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Optimal monetary policy under discretion with a zero bound on nominal interest rates

Klaus Adam () and Roberto Billi

No 380, Working Paper Series from European Central Bank

Abstract: We determine optimal discretionary monetary policy in a New-Keynesian model when nominal interest rates are bounded below by zero. Nominal interest rates should be lowered faster in response to adverse shocks than in the case without bound. Such 'preemptive easing' is optimal because expectations of a possibly binding bound in the future amplify the effects of adverse shocks. Calibrating the model to the U.S. economy we find the easing effect to be quantitatively important. Moreover, significant welfare losses. Losses increase further when inflation is partly determined by lagged inflation in the Phillips curve. Targeting positive inflation rates reduces the frequency of a binding lower bound, but tends to reduce welfare compared to a target rate of zero. The welfare gains from policy commitment, however, appear significant and are much larger than in the case without lower bound. JEL Classification: C63, E31, E52

Keywords: liquidity trap; nonlinear policy; zero lower bound (search for similar items in EconPapers)
Date: 2004-08
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