Abstract

This paper shows that the Fed’s exit strategy works as optimal monetary policy in a liquidity trap. We use the conventional new Keynesian model including a recent inflation persistence and confirm several similarities between optimal monetary policy and the Fed’s monetary policy. The zero interest rate policy continues even after inflation rates are sufficiently accelerated over the 2 percent target and hit a peak. Under optimal monetary policy, the zero interest rate policy continues until the second quarter of 2022 and the Fed terminates it one quarter earlier. Eventually, inflation rates exceed the target rate for over three years until the latest quarter. The policy rates continue to overshoot the long-run level to suppress high inflation rates. Furthermore, high inflation rates under optimal monetary policy can explain about 70 percent of the inflation data for 2021 and 2022 years. However, these are still lower than the inflation data. This is because optimal monetary policy raises the policy rates faster than the Fed does. The remaining 30 percent of inflation rates can be constrained by the Fed’s more aggressive monetary policy tightening after the zero interest rate policy.

Introduction

The theory of monetary policy has been developed since the 1990s based on a new Keynesian model as represented by Clarida et al. (1999) and Woodford (2003). Woodford (2003) finds history dependence as a general property of optimal monetary policy with commitment in a purely forward-looking new Keynesian model. He shows that the forward-looking economy and history dependence are two sides of a coin in optimal monetary policy. Eggertsson and Woodford (2003b,a), Jung et al. (2001, 2005), and Adam and Billi (2006) extend optimal monetary policy analysis with commitment to an economy in a liquidity trap and show that a robust conclusion about a feature of optimal monetary policy is history dependence. The consequence of optimal monetary policy under commitment in a liquidity trap is predicted by these papers. However, such predictions have not been evaluated in the past two decades. Now, we show the answer.

WP051

2024.07

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Abstract

This paper investigates history dependent easing known as a conventional wisdom of optimal monetary policy in a liquidity trap. We show that, in an economy where the rate of inflation exhibits intrinsic persistence, monetary tightening is earlier as inflation becomes more persistent. This property is referred as early tightening and in the case of a higher degree of inflation persistence, a central bank implements front-loaded tightening so that it terminates the zero interest rate policy even before the natural rate of interest turns positive. As a prominent feature in a liquidity trap, a forward guidance of smoothing the change in inflation rates contributes to an early termination of the zero interest rate policy.

Introduction

The theory of monetary policy has been developed since 1990s based on a new Keynesian model as represented by Clarida et al. (1999) and Woodford (2003). In particular, Woodford (2003) finds history dependence as a general property of optimal monetary policy. The optimal monetary policy rule explicitly includes lagged endogenous variables and the current monetary policy reflects the past economic environment.

2016.02

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