Heeding Daedalus: Optimal Inflation and the Zero Lower Bound

Abstract

This paper reexamines the implications for monetary policy of the zero lower bound on nominal interest rates in light of recent experience. The ZLB contributed little to the sharp output declines in many economies in 2008, but it is a significant factor slowing recovery. Model simulations imply that an additional 4 percentage points of rate cuts would have limited the rise in the U.S. unemployment rate and would bring unemployment and inflation more quickly to steady-state values, but the ZLB precludes these actions, at a cost of $1.8 trillion in forgone U.S. output over four years. If recent events presage a shift to a significantly more adverse macroeconomic climate, then 2 percent steady-state inflation may provide an inadequate buffer against the ZLB, assuming a standard Taylor rule. Stronger countercyclical fiscal policy or alternative monetary policy strategies could mitigate the ZLB's effects, but even with such policies an inflation target of 1 percent or lower could entail significant costs.

Cite this

John C. Williams (2009). Heeding Daedalus: Optimal Inflation and the Zero Lower Bound. Brookings Papers on Economic Activity. https://doi.org/10.1353/eca.0.0066

@article{c2009heeding,
  title  = {Heeding Daedalus: Optimal Inflation and the Zero Lower Bound},
  author = {Williams, John C.},
  year   = {2009},
  journal = {Brookings Papers on Economic Activity},
  doi    = {10.1353/eca.0.0066}
}

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