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Tying down the anchor: monetary policy rules and the lower bound on interest rates

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Abstract

This paper uses a standard New Keynesian model to analyze the effects and implementation of various monetary policy frameworks in the presence of a low natural rate of interest and a lower bound on interest rates. Under a standard inflation-targeting approach, inflation expectations will be anchored at a level below the inflation target, which in turn exacerbates the deleterious effects of the lower bound on the economy. Two key themes emerge from our analysis. First, the central bank can eliminate this problem of a downward bias in inflation expectations by following an average-inflation targeting framework that aims for above-target inflation during periods when policy is unconstrained. Second, dynamic strategies that raise inflation expectations by keeping interest rates ?lower for longer? after periods of low inflation can both anchor expectations at the target level and further reduce the effects of the lower bound on the economy.

Suggested Citation

  • Thomas M. Mertens & John C. Williams, 2019. "Tying down the anchor: monetary policy rules and the lower bound on interest rates," Staff Reports 887, Federal Reserve Bank of New York.
  • Handle: RePEc:fip:fednsr:887
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    References listed on IDEAS

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    1. Thomas M. Mertens & John C. Williams, 2021. "What to Expect from the Lower Bound on Interest Rates: Evidence from Derivatives Prices," American Economic Review, American Economic Association, vol. 111(8), pages 2473-2505, August.
    2. Holston, Kathryn & Laubach, Thomas & Williams, John C., 2017. "Measuring the natural rate of interest: International trends and determinants," Journal of International Economics, Elsevier, vol. 108(S1), pages 59-75.
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    6. Charles L. Evans, 2012. "Monetary Policy in a Low‐Inflation Environment: Developing a State‐Contingent Price‐Level Target," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 44(s1), pages 147-155, February.
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    10. David L. Reifschneider & John C. Williams, 2000. "Three lessons for monetary policy in a low-inflation era," Conference Series ; [Proceedings], Federal Reserve Bank of Boston, pages 936-978.
    11. Taisuke Nakata & Sebastian Schmidt, 2019. "Gradualism and Liquidity Traps," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 31, pages 182-199, January.
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    More about this item

    Keywords

    monetary policy; inflation expectations; lower bound; inflation target;
    All these keywords.

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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