Discussion Paper Series 2010-E-12

A Time-Invariant Duration Policy under the Zero Lower Bound

Kozo Ueda

Optimal commitment policy under the zero lower bound entails a high degree of complexity and time-inconsistency in a stochastic economy. This paper proposes a time-invariant duration policy that mitigates those problems and facilitates policy implementation and communication while retaining effectiveness in inflation stabilization. Under the time-invariant duration policy, a central bank commits itself to maintaining low interest rates for some duration even after adverse shocks disappear, but unlike the optimal commitment policy, the duration is independent of the ex post spell of the adverse shocks. Consequently, the time-inconsistency problem does not increase even if the ex post spell of the adverse shocks lengthens, and policy rates are expressed in an extremely simple, explicit form. Simulation results suggest that the time-invariant duration policy performs virtually as effectively as the optimal commitment policy in stabilizing inflation, and far better than a discretionary policy and simple interest rate rules with or without inertia.

Keywords: Zero lower bound on nominal interest rates; optimal monetary policy; liquidity trap; time-inconsistency

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.

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