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Sandra Daudignon
- 21 February 2023
- WORKING PAPER SERIES - No. 2788Details
- Abstract
- Empirical analyses find that the long-run natural rate, or the real rate prevailing over a long-run equilibrium where nominal rigidities are absent, is subject to permanent shocks. How should monetary policy react to such shocks? Our paper answers this question in a variant of the new Keynesian model. Because of the zero lower bound (ZLB) on nominal interest rates, the mere possibility of future movements towards zero of the long-run natural rate imparts a downward bias on inflation expectations. To offset this bias, a central bank optimizing under commitment should not only rely on forward guidance at the ZLB, as recommended by the existing literature, but also adopt an expansionary bias away from the ZLB. The neutral rate, i.e. the real policy rate consistent with stable inflation in the long-run, should fall more than one-to-one with the long-run natural rate, as the latter approaches zero. This is the case both under optimal commitment policy, and if optimal policy is implemented through a price level targeting rule.
- JEL Code
- C63 : Mathematical and Quantitative Methods→Mathematical Methods, Programming Models, Mathematical and Simulation Modeling→Computational Techniques, Simulation Modeling
E31 : Macroeconomics and Monetary Economics→Prices, Business Fluctuations, and Cycles→Price Level, Inflation, Deflation
E52 : Macroeconomics and Monetary Economics→Monetary Policy, Central Banking, and the Supply of Money and Credit→Monetary Policy