Optimal institutional design when there is a zero lower bound on interest rates

Abstract

Given the recent experience, there is a growing interest in the liquidity trap; which occurs when the nominal interest rate reaches its zero lower bound. We outline the surprising policy recommendations when there is the possibility of a zero lower bound. Then, using the Dixit-Lambertini (2003) framework of strategic policy interaction between the Treasury and the Central Bank, we …nd that the optimal institutional response to the possibility of a liquidity trap has two main components. First, an optimal in ‡ation target is given to the Central Bank. Second, the Treasury, who retains control over …scal policy and acts as Stackelberg leader, is given optimal output and in ‡ation targets. This institutional solution achieves the optimal rational expectations pre-commitment solution.

Overcoming Zero Lower Bound on Interest Rate without any Inflation or Inflationary Expectations

“…There can be strategic considerations in policy implementation and in allocation of responsibility between the treasury and the central bank in the context of the familiar solutions to the ZLB problem. For a recent article on these aspects, see Dhami and al-Nowaihi (2011). This article will abstract from these issues.…”

Inflation Linkages Within The Eurozone: Core vs. Periphery

“…Even when the economy has fallen into a liquidity trap (Krugman, ), monetary policy still plays an important role. For instance, strategic monetary–fiscal interactions remain an important policy nexus even under zero bound of interest rates (Dhami and al‐Nowaihi, ). In such an environment, precise information about the interconnectedness of inflation dynamics is essential for a well‐functioning institutional design.…”

Essays on fiscal and monetary policy interactions in a monetary union

“…In a heterogeneous union, monetary policy can be either expansionary or restrictive depending on the exit costs and on the inflation aversion by the contributing country, with low values inducing an expansionary monetary policy. Dhami and al-Nowaihi (2011) extend Dixit and Lambertini (2003a) and Lambertini and Rovelli (2004a) to allow for a liquidity trap and the effect of inflationary expectations in the aggregate supply curve.…”