Keywords: Price stability, zero bound, optimal monetary policy, liquidity trap.
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.
Full paper (300 KB PDF)
| Full paper (1326 KB Postscript)
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