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)| false Clouse, James, Dale Henderson, Athanasios Orphanides, David Small, and Peter Tinsley, 2000, “ Monetary Policy When the Nominal Short-Term Interest Rate is Zero,” Board of Governors of the Federal Reserve System, Finance and Economic Discussion Series, No. 2000–51 ( November).
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)| false Laxton, Douglasand Eswar Prasad, 1997, “ Possible Effects of European Monetary Union on Switzerland: A Case Study of Policy Dilemmas Caused by Low Inflation and the Nominal Interest Rate Floor,” IMF Working Paper No. 97/23, and forthcomingin the Journal of Policy Modeling.
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The authors would like to thank Charles Collyns, Amadou Dem, Peter Isard, Guy Meredith, Papa N’Diaye, and Jonathan Ostry for helpful comments. We are indebted to Susanna Mursula for tireless technical assistance and to Dawn Heaney for preparing the tables and charts.
Most of the research in this area has either relied upon simple closed-economy models or models that have been approximately closed.
For this initial step we use a more forward-looking rule than the original Taylor (1993) rule. Under this policy rule, the short-term nominal interest rate is adjusted, relative to a forward-looking measure of the neutral short-term nominal interest rate, in response to the output gap and the gap between core inflation and the assumed target. The original Taylor (1993) rule is more backward looking than our base-case rule because the neutral nominal interest rate is not forward looking. Because of the structure of MULTIMOD (the existence of nonlinearities and multiple sources of shocks) the original Taylor rule is a relatively inefficient rule for generating low variability in both inflation and output.
There is a growing body of research that suggests errors about the level of potential output exhibiting these properties can arise from a wide variety of the estimation techniques used to identify unobservable supply-side concepts like potential output. See Drew and Hunt (2000), Gaiduch and Hunt (2000), Isard, Laxton and Eliasson (1998), and Orphanides and van Norden (1999).
For the simulations presented in the paper, the equilibrium rates of inflation have been altered from that in the WEO baseline.
Laxton and others (1998) describe the Mark III version of MULTIMOD; see also Isard (2000). The version used in this paper incorporates several major changes. These changes include: the incorporation of a Euro Area block; new base-case specifications of the behavior of monetary and fiscal policy; and a re-coding of the model that more easily permits solutions to the model in which countries choose different steady-state rates of inflation.
Changes in policy rules will have effects on expectations in MULTIMOD because expectational variables are modeled explicitly and depend on the model’s forecasts for these variables. However, MULTIMOD may not be completely immune to the Lucas Critique. The Phillips curve, for example, is a reduced-form equation, and there is always the possibility that a major change in the pattern of monetary policy behavior could lead to significant changes in the nature of wage and price contracts and the dynamics of inflation expectations.
Allowing for nonlinearities and asymmetries in the inflation process means that large policy errors can have first-order welfare implications.
Equation 2 has been estimated for each of MULTIMOD’s major industrial countries/blocks as part of an unobserved components model that also includes equations for the deterministic NA1RU, the NAIRU, and an Okun’s Law relationship between the output gap and the unemployment gap. The estimation is done using the Kalman filter and a constrained-maximum-likelihood procedure. Equations 1 and 3 were estimated with OLS.
Comparing the sacrifice and benefit ratios in each country illustrates the direction of the asymmetry in MULTIMOD’s inflation process; the cost incurred to reduce inflation is larger than the benefit that could be derived from increasing it. When the change in inflation is restricted to be only one percentage point, the difference between the sacrifice ratio and the benefit ratio is small. However, this relationship is nonlinear so that as the changes in inflation that are considered become larger, the degree of asymmetry increases.
The degree of persistence in CPI inflation also contributes to the sacrifice and benefit ratios. For example, the difference between the sacrifice ratios for Canada and the United States is a result of a larger weight on lagged CPI inflation in the Canadian price block (0.13 for Canada versus 0.03 for the United States).
There are several possible factors that may be contributing to this property. First, imports represent a relatively small portion of the consumption bundle. Second, there is a large (albeit declining) number of regulated prices. Finally, the wage setting process in Japan is possibly more cooperative than in other industrial countries. Company profitability tends to be the most important factor underlying the variability in wages.
The base-case reaction function used here sets the short-term nominal interest rate equal to a neutral nominal interest rate plus 0.5 times the output gap plus 1.0 times the deviation from target of the current year’s core inflation. In the simulations that incorporate uncertainty about potential output, this is in fact a forecast of core inflation that will generally turn out ex-post to be incorrect. The neutral nominal interest rate is defined as an equilibrium real interest rate plus the expected rate of inflation (as given by equation 3 above).
In each baseline solution all variables are assumed to be equal to their equilibrium values.
We do not attempt to identify the structural factors underlying this shock. Several interesting hypotheses that have attempted to account for the weakness in aggregate demand in Japan can be found in Ando (2000), Morck and Nakamura (1999), and Ramaswamy and Rendu (2000).
This data is from the World Economic Outlook database.
To conduct this experiment we have generated four different baseline solutions corresponding to the four different target rates of inflation under consideration, 2.0 percent, 1.0 percent, 0.5 percent and 0.0 percent. The equilibrium nominal interest rate in each of the baselines will be equal to the equilibrium real interest rate (2.2 percent) plus the target rate of inflation.
In some cases this convergence process in the government-debt-to-GDP ratio takes longer than 20 years.
For a discussion of the properties of real-time errors associated with estimates of potential output see Drew and Hunt (2000), Gaiduch and Hunt (2000), Isard, Laxton and Eliasson (1998), and Orphanides and van Norden (1999).
This is a strong assumption and most multivariate techniques for estimating potential output would lead to a partial revision in the light of forecast errors.
The simulations assume that the monetary authority can achieve the depreciation that is desired. Svensson (2000) and McCallum (2001) argue that because the monetary authority can print money, it can announce a rate of exchange below the previously prevailing market rate and simply stand ready to sell the quantity of yen demanded at that price. Svensson argues that the value of the exchange rate would have to immediately converge to that rate for any market exchanges to occur. No one would pay a higher price than necessary for yen.
For other industrial countries the difference between these two interventions could be greater because of the larger impact of movements in the prices of imported goods on core inflation.
In practice it may be more practical to announce an upward sloping path for the target rate of inflation that converges to the long run value (2.0 percent in this example). This would be similar in spirit to the disinflation paths announce by several central banks when they initially adopted formal inflation targets.
Theoretical work examining the implications of the zero bound on nominal interest rates, like that present in Uhlig (2000) and Benhabib and others (2001), considers that multiple equilibria are a possibility under the nonlinearity caused by the zero-interest-rate floor. However, the numerical solution technique employed here is only capable of finding solution paths under which the economy converges to a steady state with the policymaker’s specified target rate of inflation without violating the non-negativity constraint. When deflationary spirals become entrenched, the solution algorithm fails because it cannot find such a path given these constraints and those of the model’s structure. As we shall show, an important component of the model’s structure that has a significant impact on the ability to find solution paths satisfying all of the constraints is the monetary policy rule.
In Reifschnider and Williams (1999), deflationary spirals, and thus solutions failures, are more easily avoided under a very similar monetary policy rule for three reasons. First, the macroeconomic model that they use, FRB/US, has more inflation persistence than does the Japan block of MULTIMOD. Second, they incorporate a fiscal policy rule that automatically stimulates the economy if interest rates are constrained at the zero bound for long periods of time. Finally, the authors increase the actual target rates of inflation that appear in the policy rule to compensate for the decline in average inflation outcomes that will otherwise arise in the face of this nonlinearity. For example, to achieve an average outcome of 0.0 percent inflation, the actual target rate for inflation specified in the policy rule is 0.7 percent.
Looking at only the set of draws that did not fail for all target rates of inflation would also bias the results towards underestimating the impact of the nonnegativity constraint. This occurs because all of the draws that embody the shocks that drive the economy into deflationary spirals under low target rates of inflation are then excluded.
We examined a policy rule that contained stronger response coefficients and the asymmetric price-level component. The addition of the stronger response coefficients actually increased the number of solution failures and the proportion of time that the constraint was binding.