DP5997 Deflationary Shocks and Monetary Rules: An Open-Economy Scenario Analysis

Author(s): Doug Laxton , Papa N'Diaye , Paolo Pesenti

Publication Date: December 2006

Keyword(s): deflation , monetary policy rules , zero interest rate floor

JEL(s): E17 , E52 , F41

Programme Areas: International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP5997.asp.asp

The paper considers the macroeconomic transmission of demand and supply shocks in an open economy under alternative assumptions on whether the zero interest floor (ZIF) is binding. It uses a two-country general-equilibrium simulation model calibrated to the Japanese economy vis-à-vis the rest of the world. Negative demand shocks have more prolonged and startling effects on the economy when the ZIF is binding than when it is not binding. Positive supply shocks can actually extend the period of time over which the ZIF may be expected to bind. More open economies hit the ZIF for a shorter period of time, and with less harmful effects. Deflationary supply shocks have different implications according to whether they are concentrated in the tradables rather than the nontradables sector. Price-level-path targeting rules are likely to provide better guidelines for monetary policy in a deflationary environment, and have desirable properties in normal times when the ZIF is not binding.