HT - 05. Zero Lower Bound

Question 1

Eggertsson and Woodford (2003):

Answer 1

Aim: Consider consequences of ZLB on nominal rates for optimal conduct of MP. Build on Krugman (1998) by adding staggered pricing.

• Key is to create right expectations of how MP will react when the ZLB is no longer binding

Conclusion: ZLB existence changes the character of optimal MP, particularly when large real disturbances are encountered in a low inflation environment. ZLB is temporarily binding and lowers welfare –> but to a modest degree as MP is not powerless

Optimal MP form of price level targeting

Question 2

Eggertsson (2008):

Answer 2

Aim: Explain how the end of US depression driven by shift in expectations. Evaluate Roosevelt consequences in a DSGE model with nominal frictions.

Conclusion: Key was the announcement of explicit objectives to bring price level down via future money supply, aided by abolishment of gold standard and accompanying fiscal policies which made it credible.

Question 3

Eggertsson (2012):

Answer 3

Aim: Show how polices that are contractionary in a neoclassical sense can be expansionary in a model with nominal frictions. During times at the ZLB with excessive deflation eg. US great depression

Conclusion: Increasing monopoly power of firms or workers can increase output. NIRA policy worked via expectations channel, boosted expected inflation, lowering real rates to boost demand.

Question 4

Eggertsson and Egiev (2020):

Answer 4

Aim: Literature summary on liquidity trap

Conclusion: demand driven recessions forcing the economy to hit the ZLB appears to explain well both the great depression and great recession for appropriate calibrations of expected crisis duration.

Question 5

Topic Summary (3)

Answer 5

• MP can still have effects on current output at the ZLB/ELB if either…
o CB can influence expectations about future inflation while at the ZLB or…
o CB can influence expectations on the real rate (via nominal rate) once the ZLB no longer binds  “FG”

• Expectations and ability to commit!
  • Discretion –> No credibility to commit –> Nothing can do –> Large welfare cost
  • Commitment –> Other tools available, little welfare cost

• Lower bound is below zero but exists and acts as a real constraint for policy makers when hit with large negative demand driven recessions –> Shock to the natural real interest rate eg. Discount factor
• AD becomes upward sloping at the ZLB –> Key is role of expectations, linked to expected duration of the crisis
• Taylor Rule is no longer optimal at the ZLB –> Optimal MP becomes history dependent, keep interest rates artificially low post the crisis ending to boost expectations of future inflation
o Theoretical underpinning of “forward guidance”

Question 6

Eggertsson and Woodford (2003), Jung, Teranishi and Watanabe (2005), Nakov (2008)

Answer 6

• Credible commitment is key to mitigating ELB constraint consequences
• Two state process for the natural real interest rate simplifying analysis.

– ZLB existence alters optimal MP when large shocks can hit, constrained optimum is form of constant price level targeting….even simpler nominal GDP targeting rule does a good job at ZLB. Built on Krugman (1998) by adding in staggered pricing

Question 7

Eggertsson (2008, 2012) –

Answer 7

• Announcement of explicit objectives to bring down price level via money supply commitments helped US get out of depression as well as eliminating policy dogmas. Similar to Kydland and Prescott (1977)

Question 8

Adam and Billi (2006, 2007)

Answer 8

– implications of occasionally but recurrently binding ZLB for optimal MP, commitment is key!

Question 9

Benhabib, Schmitt-Grohe and Uribe (2001, 2002)

Answer 9

– CB follows a Taylor Rule, ZLB –> 2 steady states exist, one being a “liquidity trap” with binding ZLB and inefficiently low output and inflation

• Promise of huge fiscla deficits to escape liquidity traps

Question 10

Nakata and Schmidt (2014)

Answer 10

– conservative CB with occasionally binding ZLB

Question 11

Bernanke and Reinhart (2004)

Answer 11

2008-2015 the US Fed Funds rate was fixed at the ELB, 0-0.25%

Question 12

Correia et. al (2013)

Answer 12

Fiscal policy can influence the equilibrium natural real interest rate at the ZLB…models usually treat as exogenous.

Question 13

Bodenstein, Hebden and Nunes (2012)

Answer 13

Imperfect credibility at the ZLB may mean CB has to make more extreme promises about future interest rates to have an equally stailising effect.

Question 14

Braun, Korber and Waki (2012)

Gavin et. al (2015), Mertens and Ravn (2014)

Answer 14

Key assumption around slopes can give multiple equilibria at eh ZLB including x = pi = 0, and the nominal = real rate and ELB not binding if NKPC steeper than IS.

Several papers explore ELB equilibria multiplicity.