An interest rate rule to uniquely implement the optimal equilibrium in a liquidity trap

Abstract: We propose a new interest rate rule that implements the optimal equilibrium and eliminates all indeterminacy in a canonical New Keynesian model in which the zero lower bound on nominal interest rates (ZLB) is binding. The rule commits to zero nominal interest rates for a length of time that increases in proportion to how much past inflation has deviated?either upward or downward?from its optimal level. Once outside the ZLB, interest rates follow a standard Taylor rule. Following the Taylor principle outside the ZLB is neither necessary nor sufficient to ensure uniqueness of equilibria. Instead, the key principle is to respond strongly enough to deviations of past inflation from optimal levels by sufficiently increasing the amount of time interest rates are promised to be kept at zero.

Keywords: indeterminacy; monetary policy; zero lower bound; forward guidance; ZLB; Taylor principle; liquidity trap; interest rate rule; Taylor rule; New Keynesian model;

JEL Classification: E58; E52; E43;


Bibliographic Information

Provider: Federal Reserve Bank of New York

Part of Series: Staff Reports

Publication Date: 2015-10-01

Number: 745

Pages: 41 pages

Note: The full text of this report is no longer available. For related work, see Fernando Duarte, “How to Escape a Liquidity Trap with Interest Rate Rules,” Federal Reserve Bank of New York Staff Reports, no. 776, May 2016.