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Price stability and monetary policy effectiveness when nominal interest rates are bounded at zero (1998)
| Venue: | FINANCE AND ECONOMICS DISCUSSION SERIES, 98-35, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM |
| Citations: | 108 - 26 self |
BibTeX
@INPROCEEDINGS{Orphanides98pricestability,
author = {Athanasios Orphanides and Volker Wieland},
title = {Price stability and monetary policy effectiveness when nominal interest rates are bounded at zero},
booktitle = {FINANCE AND ECONOMICS DISCUSSION SERIES, 98-35, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM},
year = {1998},
publisher = {}
}
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Abstract
This paper employs stochastic simulations of a small structural rational expectations model to investigate the consequences of the zero bound on nominal interest rates. We find that if the economy is subject to stochastic shocks similar in magnitude to those experienced in the U.S. over the 1980s and 1990s, the consequences of the zero bound are negligible for target inflation rates as low as 2 percent. However, the effects of the constraint are non-linear with respect to the inflation target and produce a quantitatively significant deterioration of the performance of the economy with targets between 0 and 1 percent. The variability of output increases significantly and that of inflation also rises somewhat. The stationary distribution of output is distorted with recessions becoming somewhat more frequent and longer lasting. Our model also uncovers that the asymmetry of the policy ineffectiveness induced by the zero bound generates a non-vertical long-run Phillips curve. Output falls increasingly short of potential with lower inflation targets. At zero average inflation, the output loss is in the order of 0.1 percentage points. We also investigate the consequences of the constraint on the analysis of optimal policy based on the inflation-output variability frontier. We demonstrate that in the presence of the zero bound, the variability frontier is distorted as the inflation target approaches zero. As a result comparisons of alternative policy rules that ignore the zero bound can be seriously misleading.
Keyphrases
zero bound nominal interest rate monetary policy effectiveness price stability inflation target output increase output loss non-vertical long-run phillips curve percentage point optimal policy result comparison stochastic shock average inflation small structural rational expectation model stochastic simulation inflation-output variability frontier variability frontier alternative policy rule stationary distribution target inflation rate policy ineffectiveness inflation target approach zero significant deterioration
