Working Paper

Discretionary monetary policy and the zero lower bound on nominal interest rates

Abstract: Ignoring the existence of the zero bound on nominal interest rates one considerably understates the value of monetary commitment in New Keynesian models. A stochastic forward-looking model with an occasionally binding lower bound, calibrated to the U.S. economy, suggests that low values for the natural rate of interest lead to sizeable output losses and deflation under discretionary monetary policy. The fall in output and deflation are much larger than in the case with policy commitment and do not show up at all if the model abstracts from the existence of the lower bound. The welfare losses of discretionary policy increase even further when inflation is partly determined by lagged inflation in the Phillips curve. These results emerge because private sector expectations and the discretionary policy response to these expectations reinforce each other and cause the lower bound to be reached much earlier than under commitment.

Keywords: Monetary policy; Liquidity (Economics); Interest rates;

Bibliographic Information

Provider: Federal Reserve Bank of Kansas City

Part of Series: Research Working Paper

Publication Date: 2005

Number: RWP 05-08