Monetary Policy Frameworks and the Effective Lower Bound on Interest Rates

2019-01 | June 1, 2019

This paper applies a standard New Keynesian model to analyze the effects of monetary policy in the presence of a low natural rate of interest and a lower bound on interest rates. Under a standard inflation-targeting approach, inflation expectations will be anchored at a level below the inflation target, which in turn exacerbates the deleterious effects of the lower bound on the economy. Two key themes emerge from our analysis. First, the central bank can mitigate this problem of a downward bias in inflation expectations by following an average-inflation targeting framework that aims for above-target inflation during periods when policy is unconstrained. Second, a dynamic strategy such as price-level targeting that raises inflation expectations when inflation is low can both anchor expectations at the target level and potentially further reduce the effects of the lower bound on the economy.

Article Citation

Williams, John C., and Thomas M. Mertens. 2019. “Monetary Policy Frameworks and the Effective Lower Bound on Interest Rates,” Federal Reserve Bank of San Francisco Working Paper 2019-01. Available at https://doi.org/10.24148/wp2019-01

About the Authors
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Thomas Mertens is a vice president in the Economic Research Department of the Federal Reserve Bank of San Francisco. Learn more about Thomas Mertens
John C. Williams served as President and Chief Executive Officer of the Federal Reserve Bank of San Francisco from March 1, 2011 to June 17, 2018. Dr. Williams was previously the executive vice president and director of research for the San Francisco bank, which he joined in 2002. He began his career in 1994 as an […] Learn more about John C. Williams