Abstract: This paper employs stochastic simulations of a small structural rational
expectations model to investigate the consequences of the zero bound
constraint on nominal interest rates.
We find that if the economy is subject to stochastic shocks similar in
magnitude to those experienced in the U.S. over the 1980s and 1990s, the
consequences of the zero bound are negligible for target inflation rates as
low as 2 percent. However, the effects of the constraint are very nonlinear
with respect to the inflation target and produce a quantitatively
significant deterioration of the performance of the economy with targets
between 0 and 1 percent. The variability of output increases significantly
and that of inflation also rises somewhat. The stationary distribution of
output is distorted, with recessions becoming somewhat more frequent and
longer lasting. Our model also uncovers the fact the asymmetry of the policy
ineffectiveness induced by the zero bound constraint generates a
nonvertical long run Phillips curve. Output falls increasingly short of
potential, with lower inflation targets. At zero average inflation, the
output loss is on the order of 0.1 percentage points. We also investigate
the consequences of the constraint on the analysis of optimal policy based
on the inflationoutput variability frontier. We demonstrate that in the
presence of the zero bound, the variability frontier is distorted as the
inflation target approaches zero. As a result, comparisons of alternative
policy rules that ignore the zero bound can be seriously misleading.
Keywords: Monetary policy, price stability, zero interest rate bound, liquidity trap, rational expectations
Full paper (742 KB PDF)
 Full paper (1485 KB Postscript)
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