The Zero Bound on Interest Rates and Optimal Monetary Policy

We consider the consequences for monetary policy of the zero floor for nominal interest rates. The zero bound can be a significant constraint on the ability of a central bank to combat deflation. We show, in the context of an intertemporal equilibrium model, that open-market operations, even of "unconventional" types, are ine#ective if future policy is expected to be purely forward-looking. Nonetheless, a credible commitment to the right sort of history-dependent policy can largely mitigate the distortions created by the zero bound. In our model, optimal policy involves a commitment to adjust interest rates so as to achieve a time-varying price-level target, when this is consistent with the zero bound. We also discuss ways in which other central-bank actions, while irrelevant apart from their e#ects on expectations, may help to make credible a central bank's commitment to its target # We would like to thank Tamim Bayoumi, Ben Bernanke, Mike Dotsey, Ben Friedman, Stefan Gerlach, Mark Gertler, Marvin Goodfriend, Ken Kuttner, Maury Obstfeld, Athanasios Orphanides, Dave Small, Lars Svensson, Harald Uhlig, Tsutomu Watanabe, and Alex Wolman for helpful comments, and the National Science Foundation for research support through a grant to the NBER. The views expressed in this paper are those of the authors and do not necessarily represent those of the IMF or IMF policy