Abstract

We study the design of monetary policy in a low inflation environment taking into account the limitations imposed by the zero bound on nominal interest rates. Using numerical dynamic programming methods, we compute optimal policies in a simple, calibrated openeconomy model and evaluate the e#ect of the liquidity trap generated by the zero bound. We consider the possibility that the quantity of base money may a#ect output and inflation even when the interest rate is constrained at zero and explicitly account for the substantial degree of uncertainty regarding such quantity e#ects. As an example of such a quantity e#ect, we focus on the portfolio balance channel through which changes in relative money supplies influence the exchange rate. We find that the optimal policy near price stability is asymmetric, that is, as inflation declines, policy turns expansionary sooner and more aggressively than would be optimal in the absence of the zero bound. As a consequence, the average level of inf...

Citations