Discussion Paper Series 2008-E-20

The Zero Interest Rate Policy

Tomohiro Sugo, Yuki Teranishi

This paper derives a generalized optimal interest rate rule that is optimal even under a zero lower bound on nominal interest rates in an otherwise basic New Keynesian model with inflation inertia. Using this optimal rule, we investigate optimal entrance and exit strategies of the zero interest rate policy (ZIP) under the realistic model with inflation inertia and a variety of shocks. The simulation results reveal that the shapes of the entrance and exit strategies in a ZIP change considerably according to the forward- or backward-lookingness of the economy and the size of the shocks. In particular, for large shocks that result in long ZIP periods, the time to the start (end) of the ZIP period is earlier (later) in an economy with inflation inertia than in a purely forward-looking economy. However, these outcomes are surprisingly converse to small shocks that result in short ZIP periods.

Keywords: Zero Interest Rate Policy; Optimal Interest Rate Rule

Views expressed in the paper are those of the authors and do not necessarily reflect those of the Bank of Japan or Institute for Monetary and Economic Studies.

Copyright © 2008 Bank of Japan All Rights Reserved.

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