DP4585 Optimal Monetary Policy Under Discretion with a Zero Bound on Nominal Interest Rates

Author(s): Klaus Adam , Roberto M Billi

Publication Date: August 2004

Keyword(s): C63 , nonlinear policy , zero lower bound , liquidity trap

JEL(s): E31 , E52

Programme Areas: International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP4585.asp

We determine optimal discretionary monetary policy in a New Keynesian model when nominal interest rates are bounded below by zero. Nominal interest rates should be lowered faster in response to adverse shocks than in the case without bound. Such ‘pre-emptive easing’ is optimal because expectations of a possibly binding bound in the future amplify the effects of adverse shocks. Calibrating the model to the US economy we find the easing effect to be quantitatively important. Moreover, the lower bound binds rather frequently and imposes significant welfare losses. Losses increase further when inflation is partly determined by lagged inflation in the Phillips curve. Targeting positive inflation rates reduces the frequency of a binding lower bound, but tends to reduce welfare compared to a target rate of zero. The welfare gains from policy commitment, however, appear significant and are much larger than in the case without lower bound.