On the Function of the Zero Interest Rate Commitment: Monetary Policy Rules in the Presence of the Zero Lower Bound on Interest Rates

We analyze the effectiveness of monetary policy rules in the presence of the zero lower bound on nominal interest rates, using stochastic simulations. Specifically, we assume a small structural model composed of the IS and AS curves with both forward-looking and backward-looking agents, and estimate the model using Japanese economic data. Based on the results, we investigate which monetary policy rule is superior, in terms of minimizing social loss, among various policy rules which take the zero lower bound constraint into account. We assume a simple Taylor-type monetary policy rule estimated using the data before the zero interest rate policy was adopted as the baseline policy rule. We then modify this policy rule by adding a policy commitment whereby if deflation occurs the zero interest rate policy will be maintained until the rate of inflation rises beyond a specific level. The analyses indicate that such policy rules can be effective if the contents of the commitment -- that is, the conditions for maintaining the zero interest rate policy -- are set appropriately based on the economic conditions when the commitment is implemented. We also find that monetary policy rules with a nonlinearity, whereby preemptive monetary easing is appropriately implemented as the nominal interest rate approaches zero, perform well if they are regarded as credible, even without any explicit policy commitment.