Three Lessons for Monetary Policy in a Low Inflation Era

Abstract

The zero lower bound on nominal interest rates constrains the central bank's ability to stimulate the economy during downturns. We use the FRB US model to quantify the e ects of the bound on macroeconomic stabilization and to explore how policy can be designed to minimize these e ects. During particularly severe contractions, open-market operations alone may be insu cient to restore equilibrium; some other stimulus is needed. Abstracting from such rare events, if policy follows the Taylor rule and targets a zero in ation rate, there is a signi cant increase in the variability of output but not in ation. However, a simple modi cation to the Taylor rule yields a dramatic reduction in the detrimental e ects of the zero bound.

The Taylor Principle and Monetary Policy Approaching a Zero Bound on Nominal Rates: Quantile Regression Results for the United States and Japan

“…Rather, the response weakened as interest rates became very low. While it is possible that the Bank of Japan acted insufficiently strongly and not soon enough, and therefore missed a vital opportunity to avoid deflation, it is also possible that our result reflects the decision of the Bank of Japan to rely on alternative monetary policy measures suggested by Blinder (2000), McCallum (2000), Reifschneider and Williams (2000), Eggertsson and Woodford (2003), Bernanke and Reinhart (2004), and Coenen and Wieland (2004), among others. It did not have exclusive reliance on the short‐term interest rate (Ito and Mishkin 2004) and therefore it did not need to act in the aggressive manner described by Kato and Nishiyama (2005).…”

“…Aggressive behavior on the part of the central bank would cause the expected inflation to fall by less in response to the initial shock, since the private sector will take into account the pattern of the central bank's behavior. This issue has been central to the debate concerning monetary policy under very low interest rates (Blinder 2000, McCallum 2000, Reifschneider and Williams 2000, Ueda 2000, 2004, Kuttner and Posen 2001, 2004, Eggertsson and Woodford 2003, Bernanke and Reinhart 2004, Coenen and Wieland 2004, Jung, Teranishi, and Watanabe 2005, Kato and Nishiyama 2005, Adam and Billi 2006). Calibrated models with a lower bound on the nominal rate imply monetary authorities have an incentive to respond “more aggressively than suggested by a model without a lower bound” (Adam and Billi 2006, p. 1877).…”

Monetary Policy and the Lost Decade: Lessons from Japan

“…The model is solved using standard methods, and the nonnegativity constraint is imposed using the procedure of Reifschneider and Williams (2000). In particular, the linear model described by is first solved while abstracting from the zero interest rate floor following the approach of Sims (2002).…”

“…In particular, the linear model described by is first solved while abstracting from the zero interest rate floor following the approach of Sims (2002). The zero interest rate floor is then imposed on the model solution following Reifschneider and Williams by augmenting the nominal interest rate equation with additive disturbances for the current period and for a finite number of future periods. These disturbances equal zero if the policy rule implies a positive interest rate, and equal the absolute value of the unconstrained rate if the rule implies a negative value.…”

“…28 28 Several studies, such as Reifschneider and Williams (2000) and Hunt and Laxton (2003), find that an inflation target greater than 2% substantially reduces the probability of hitting the zero bound. …”