Zero Lower Bound and Monetary Policy in the Euro Area (PDF)

the studies that were presented above imply that the zero bound is a probable constraint for the conduct of monetary policy in a low inflation environment it has to be determined how large these distortions are. To do this a model of the European economy is used to derive the distortions when monetary authority follows a Taylor rule. Inflation distortions: The zero bound leads to somewhat tighter monetary policy compared to what would occur in the absence of the bound. This is the case for inflation targets set close to zero because then the probability that the bound binds is larger. This tighter monetary policy leads to a downward bias in the rate of inflation as the graph below shows. The squares represent the outcome for Taylor style contracts and the diamonds the Fuhrer-Moore contracting (Graph 7).The downward bias is stronger for the Fuhrer-Moore contracting. But as the probability to hit the bound decreases with larger inflation targets the bias decreases too at a larger inflation target. With Taylor contracting the bias is reduced to zero when the target is set to two per cent. However, with Fuhrer-Moore contracting is not even at a target rate of four per cent reduced to zero. The standard deviation of the rate of inflation is higher for Taylor contracting than in the case when the zero bound is not a constraint while the standard deviation with Fuhrer-Moore contracting is reduced. And again at an inflation target of two per cent the change in the standard deviation with Taylor contracting vanishes. Output distortions: As with inflation there is also a downward bias in the mean of output. With the zero bound output falls short of potential output by 0.1 percentage points with Taylor contracting at an inflation target set to zero. When the inflation target is set to two per cent it is almost reduced to zero. The distortions are somewhat stronger for the Fuhrer-Moore contracting specification. With 0.14 percentage points at an inflation target of zero it is not very large. However, it does not return to zero as quickly as under Taylor contracting when the inflation target is lifted. The downward bias occurs due to the tighter monetary policy when policy is constrained by the zero interest rate bound (Graph 8).The standard deviation of output is higher for both wage contracting specifications. But the rise is not significant for Taylor contracting.The graphs above show that the distortions can be lowered by raising the inflation target. With Taylor contracting a two per cent inflation target reduces the distortions almost to zero. With Fuhrer-Moore contracting the inflation target should be raised up to four per cent so that only minor disturbances are left. However, this recommendation is not very helpful for policy makers because inflation itself is costly and causes distortions in the economy which will lower welfare. The full benefits of price stability are achieved at zero inflation when the zero bound is not a constraint. The ECB decided to raise its target for the rate of inflation and the graphs above showed that this will lower the distortions of the bound significantly. But this is done by accepting the cost of higher inflation which have not been considered in the simulations. The main costs are price dispersion which leads to ineffective production. This lowers the level of output and lowers welfare through this.