Discretionary Monetary Policy and the Zero Lower Bound on Nominal Interest Rates

By Klaus Adam and Roberto M. Billi
First version: October 3, 2003
This version: November 11, 2005
 RWP 05-08
Research Division 
Federal Reserve Bank of Kansas City 

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: nonlinear optimal policy, occasionally binding constraint, sequential policy, Markov perfect equilibrium, liquidity trap

JEL classification: E31, E52

*Klaus Adam is a senior economist at the European Central Bank and Roberto Billi is an economist at the Federal Reserve Bank of Kansas City. This paper is forthcoming in the “Journal of Monetary Economics.” We would like to thank an anonymous referee who provided helpful comments and suggestions. Errors remain ours. The views expressed herein are solely those of the authors and do not necessarily reflect the views of the European Central Bank, the Federal Reserve Bank of Kansas City or the Federal Reserve System.

Adam email: Klaus.Adam@ecb.int
Billi email: Roberto.Billi@kc.frb.org

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