The Zero Lower Bound

In the standard New Keynesian model, monetary policy is often described by an interest rate rule (e.g. a Taylor rule) that moves the interest rate in response to deviations of inflation and some measure of economic activity from target. Nominal interest rates are bound from below by 0 – since money is storable, one would never accept a negative nominal return. How does the behavior of the NK model change when interest rates hit zero and cannot freely adjust in response to changing economic conditions? To answer this question, we consider the implications of an interest rate peg in the model. This isn’t literally what happens at the zero lower bound, but what matters in the model is not that the interest rate is zero per se, but rather that it becomes unresponsive to economic conditions. In the experiments I consider, the nominal interest rate is pegged at a fixed value for a finite (and deterministic) period of time. After the peg, monetary policy obeys a simple Taylor rule. It turns out to be relatively straightforward to modify a Dynare code to take this into account. I include a government spending shock in the model so that we can analyze the effects of government spending shocks at the zero lower bound, which has been a topic of much recent interest. The interest rate peg ends up exacerbating the effects of price stickiness. In particular, output responds even less to a positive supply shock (productivity) and more to “demand” shocks (government spending) than under a standard Taylor rule. This operates through an inflation channel and the Fisher relationship: positive supply shocks lower inflation, which raises real interest rates if nominal rates are unresponsive, with the reverse holding for a demand shock like government spending.