Working Paper

Gradualism and Liquidity Traps

Abstract: Modifying the objective function of a discretionary central bank to include an interest-rate smoothing objective increases the welfare of an economy in which large contractionary shocks occasionally force the central bank to lower the policy rate to its effective lower bound. The central bank with an interest-rate smoothing objective credibly keeps the policy rate low for longer than the central bank with the standard objective function. Through expectations, the temporary overheating of the economy associated with such a low-for-long interest rate policy mitigates the declines in inflation and output when the lower bound constraint is binding. In a calibrated model, we find that the introduction of an interest-rate smoothing objective can reduce the welfare costs associated with the lower bound constraint by more than one-half.

Keywords: Gradualism; Inflation Targeting; Interest-Rate Smoothing; Liquidity Traps; Zero Lower Bound;

JEL Classification: E52; E61;

https://doi.org/10.17016/FEDS.2016.092

Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: Finance and Economics Discussion Series

Publication Date: 2016-11

Number: 2016-092

Pages: 29 pages