Keywords: Zero bound, monetary policy, expectations formation, macroeconomic models
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.
Full paper (280 KB PDF)
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