Abstract
What should a central bank do when faced with a weak aggregate demand even after reducing the short-term nominal interest rate to zero? To address this question, we solve a central bank's intertemporal loss-minimization problem, in which the non-negativity constraint on nominal interest rates is explicitly considered. We find that the optimal path is characterized by policy inertia, in the sense that a zero interest rate policy should be continued for a while even after the natural rate of interest returns to a positive level. By making such a commitment, the central bank is able to achieve higher expected inflation, lower long-term nominal interest rates, and a weaker domestic currency in the adverse periods when the natural rate of interest significantly deviates from a steady-state level.
Original language | English |
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Pages (from-to) | 813-835 |
Number of pages | 23 |
Journal | Journal of Money, Credit and Banking |
Volume | 37 |
Issue number | 5 |
DOIs | |
Publication status | Published - 2005 Oct |
Externally published | Yes |
Keywords
- Liquidity trap
- Monetary policy inertia
- The zero bound on nominal interest rates
- Zero interest rate policy
ASJC Scopus subject areas
- Accounting
- Finance
- Economics and Econometrics