Efficient monetary policy design near price stability

Athanasios Orphanides and Volker Wieland

No 1999-67, Finance and Economics Discussion Series from Board of Governors of the Federal Reserve System (U.S.)

Abstract: We study the design of monetary policy in a low inflation environment taking into account the limitations imposed by the zero bound on nominal interest rates. Using numerical dynamic programming methods, we compute optimal policies in a simple, calibrated open-economy model and evaluate the effect of the liquidity trap generated by the zero bound. We consider the possibility that the quantity of base money may affect output and inflation even when the interest rate is constrained at zero and explicitly account for the substantial degree of uncertainty regarding such quantity effects. As an example of such a quantity effect, we focus on the portfolio balance channel through which changes in relative money supplies influence the exchange rate. We find that the optimal policy near price stability is asymmetric, that is, as inflation declines, policy turns expansionary sooner and more aggressively than would be optimal in the absence of the zero bound. As a consequence, the average level of inflation is biased upwards. These results indicate that policymakers are faced with a tradeoff between the level of inflation and economic stabilization performance when the economy is operating near the zero bound. Finally, we discuss operational issues associated with the interpretation and implementation of policy at the zero bound in relation to the recent situation in Japan.

Keywords: Monetary policy; Interest rates; Inflation (Finance) (search for similar items in EconPapers)
Date: 1999
New Economics Papers: this item is included in nep-ifn and nep-mon
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (14)

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Related works:
Journal Article: Efficient Monetary Policy Design near Price Stability (2000)
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