Risk Shocks Close to the Zero Lower Bound

Martin Seneca

No 107, 2017 Meeting Papers from Society for Economic Dynamics

Abstract: Risk shocks give rise to cost-push effects in the canonical New Keynesian model if they are large relative to the distance between the nominal interest rate and its zero lower bound (ZLB). Therefore, stochastic volatility introduces occasional trade-offs for monetary policy between inflation and output gap stabilisation. The trade-off inducing effects operate through expectational responses to the interaction between perceived shock volatility and the ZLB. At the same time, a given monetary policy stance becomes less effective when risk is high. Optimal monetary policy calls for potentially sharp reductions in the interest rate when risk is elevated, even if this risk never materialises. If the underlying level of risk is high, inflation will settle potentially materially below target in a risky steady state even under optimal monetary policy.

Date: 2017
New Economics Papers: this item is included in nep-dge, nep-mac and nep-mon
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Working Paper: Risk shocks close to the zero lower bound (2016)
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Persistent link: https://EconPapers.repec.org/RePEc:red:sed017:107

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