Interest Rate Rules, Forward Guidance Rules and the Zero Lower Bound on Nominal Interest Rates in a Cost Channel Economy

The main aim of this study is to examine the behaviour of main macroeconomic variables under some interest rate rules and a forward guidance rule in a cost channel economy1 in the presence of the ZLB. The ZLB is considered as an occasionally binding constraint. Interest rate rules are represented by Taylor-type truncated rules (TTR) while the forward guidance (FG) rule is an endogenous threshold-based rule. Under TTRs, first, the cost channel economy is more likely to fall into a liquidity trap and remain longer compared to the no-cost channel economy. Second, the risky steady state of a cost channel economy has more deflation bias than a no-cost channel economy. Third, the welfare loss is higher when uncertainty is high and it is appreciably higher in cost channel economies. Under the FG rule, compared to the TTR, the following results hold, irrespective of the cost channel: First, an appropriate FG rule can avoid deflation bias while strict FG leads to an inflation bias. Second, the FG rule reduces the frequency of liquidity-trapped recessions. Third, the depth of the recession under the FG rule is lower. The existence of the cost channel amplifies the inflation bias under the FG rule. The findings of this study suggest that if a cost channel was present in an economy, the transmission of monetary policy may be different from that in a no-cost channel economy in the presence of the ZLB. Additionally, if agents expect future recessions, achieving the inflation target is more challenging in cost channel economies. Therefore, central banks should pay careful attention to the cost channel of monetary policy when they set policies under such economic conditions. Further, this study finds that the endogenous FG rule improves welfare compared to the interest rules considered.