Optimal Monetary Policy when Interest Rates are Bounded at Zero

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Institute for Monetary and Economic Studies, Bank of Japan, 2003 - Interest rates - 37 pages
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This paper characterizes the optimal monetary policy reaction function in the presence of a zero lower bound on the nominal interest rate. We analytically prove and numerically show that the function is highly nonlinear, more expansionary, and more aggressive than the Taylor rule. We then test its empirical validity taking the case of Japan in the 1990s. Qualitatively, we find some evidence of nonlinear monetary policy. Quantitatively, we find the actual monetary policy to be too contractionary during the first half of the decade, while the low interest policy during the latter half turns out to be fairly consistent with the simulated path.

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