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Expectations formation and the effectiveness of strategies for limiting the consequences of the zero bound on interest rates

David L. Reifschneider and John Roberts

No 2005-70, Finance and Economics Discussion Series from Board of Governors of the Federal Reserve System (U.S.)

Abstract: We use simulations of the Federal Reserve's FRB/US model to examine the efficacy of a number of proposals for reducing the consequences of the zero bound on nominal interest rates. Among the proposals are: a more aggressive monetary policy; promises to make up any shortfall in monetary ease during the zero-bound period by keeping interest rates lower in the future; and the adoption of a price-level target. We consider two assumptions about expectations formation. One assumption is fully model-consistent expectations (MCE)--a reasonable assumption when a policy has been in place for some time, but perhaps less so for a newly announced policy. We therefore also consider the possibility that only financial markets have MCE, and that other agents form their expectations using a small-scale VAR model estimated using historical data. All of the policies noted above are highly effective at reducing the adverse effects of the zero bound under MCE, but their efficacy drops considerably when households and firms base their expectations on the historical average behavior of the economy, and only investors fully recognize the economic implications of the various proposals.

Keywords: Interest rates; Monetary policy; Econometric models (search for similar items in EconPapers)
Date: 2005
New Economics Papers: this item is included in nep-cba, nep-fmk, nep-mac and nep-mon
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