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Reading: Monetary policy at the zero lower bound: Discretion, uncertainty and interest rate volatility

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Monetary policy at the zero lower bound: Discretion, uncertainty and interest rate volatility

Author:

Mark A.C. Wilkinson

London School of Economics and Political Science, GB
About Mark A.C.

Master of Public Administration, Class of 2016

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Abstract

This study investigates optimal monetary policy under a set of simultaneous constraints: i) when nominal interest rates are at their zero lower bound (ZLB), ii) when there is uncertainty about the natural interest rate, and iii) when the central bank cannot make credible commitments. In these situations, there are asymmetric risks in setting monetary policy, as the ZLB prevents the central bank from further decreasing nominal rates to stimulate the economy, and unconventional monetary policy is an imperfect substitute for the constrained traditional interest rate instrument. There is therefore a trade-off between keeping interest rates lower for longer, to ensure recovery, and beginning to raise rates earlier but more gradually. To assess the ability of different policies to handle this trade-off, I use a New Keynesian dynamic stochastic general equilibrium model with monetary policy defined either by a standard Taylor rule or discretionary inflation targeting that considers uncertainty. The central finding is that an optimal discretionary policy augmented to account for uncertainty about the natural interest rate forcing the ZLB to bind can perform as well or better than the Taylor rule by staying lower for longer, even though the discretionary policy has a more volatile policy rate. A further result is that a Rogoff-type conservative central banker who puts a high relative weight on stabilizing inflation can alleviate the deflationary pressure of the ZLB episode.

How to Cite: Wilkinson, M.A.C., 2017. Monetary policy at the zero lower bound: Discretion, uncertainty and interest rate volatility. The Public Sphere: Journal of Public Policy, 5(1), pp.255–278.
Published on 01 Jan 2017.
Peer Reviewed

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