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Optimal Monetary Policy at the Zero-Interest-Rate Bound
- Journal of Money, Credit, and Banking
- The Ohio State University Press
- Volume 37, Number 5, October 2005
- pp. 813-835
- 10.1353/mcb.2005.0053
- Article
- Additional Information
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.