Brookings Papers ON ECONOMIC ACTIVITY

BROOKINGS INSTITUTION PRESS

Contents

Editors' Summary..................................................................................................................................................................viiJOHN C. WILLIAMS Heeding Daedalus: Optimal Inflation and the Zero Lower Bound....................................................................................................1Comment by Michael Woodford.......................................................................................................................................................38General Discussion................................................................................................................................................................45SUMIT AGARWAL, JOHN C. DRISCOLL, XAVIER GABAIX, and DAVID LAIBSON The Age of Reason: Financial Decisions over the Life Cycle and Implications for Regulation.....................51Comments by Giovanni Dell'Ariccia and Karen M. Pence..............................................................................................................................102General Discussion................................................................................................................................................................111RICARDO REIS Interpreting the Unconventional U.S. Monetary Policy of 2007–09...............................................................................................119Comments by Timothy Besley and Donald L. Kohn.....................................................................................................................................166General Discussion................................................................................................................................................................176ROBERT E. HALL By How Much Does GDP Rise If the Government Buys More Output?.....................................................................................................183Comments by Alan J. Auerbach and Christopher L. House.............................................................................................................................232General Discussion................................................................................................................................................................244CARMEN M. REINHART AND VINCENT R. REINHART When the North Last Headed South: Revisiting the 1930s................................................................................251Comment by Chang-Tai Hsieh........................................................................................................................................................273General Discussion................................................................................................................................................................276

Chapter One

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.

Icarus, my son, I charge you to keep at a moderate height, for if you fly too low the damp will clog your wings, and if too high the heat will melt them. —Bulfinch's Mythology, Chapter XX

Japan's sustained deflation and near-zero short-term interest rates beginning in the 1990s prompted an outpouring of research on the implications of the zero lower bound (ZLB) on nominal interest rates for monetary policy and the macroeconomy. In the presence of nominal rigidities, the ZLB will at times constrain the central bank's ability to reduce nominal, and thus real, interest rates in response to negative shocks to the economy. This inability to reduce real rates as low as desired impairs the ability of monetary policy to stabilize output and inflation. The quantitative importance of the ZLB depends on how often and how tightly the constraint binds, a key determinant of which is the steady-state inflation rate targeted by the central bank. If that rate is sufficiently high, the ZLB will rarely impinge on monetary policy and the macroeconomy. If sufficiently low, the ZLB may have more deleterious effects. All else equal, then, the presence of the ZLB argues for a higher steady-state inflation rate.

Of course, not all else is equal. Since Martin Bailey (1956), economists have identified and studied other sources of distortions related to inflation besides the ZLB. Several of these—including transactions costs, real distortions associated with nonzero rates of inflation, and non-neutralities in the tax system—argue for targeting steady-state inflation rates of zero or below. Others—including asymmetries in wage setting, imperfections in labor markets, distortions related to imperfect competition, and measurement bias—argue for positive steady-state inflation (see, for example, Akerlof, Dickens, and Perry 1996). Balancing these opposing influences, central banks around the globe have sought to heed the mythical Greek inventor Daedalus's advice to his son by choosing an inflation goal neither too low nor too high. In practice, many central banks have articulated annual inflation goals centered on 2 to 3 percent (Kuttner 2004). Simulations of macroeconomic models where monetary policy follows a version of the Taylor (1993) rule indicate that with an inflation target of 2 percent, the ZLB will act as a binding constraint on monetary policy relatively frequently (Reifschneider and Williams 2000; Billi and Kahn 2008). But these simulations also predict relatively modest effects of the ZLB on macroeconomic volatility with a 2 percent target, because the magnitude of the constraint will be relatively small and its duration relatively brief. Only with inflation targets of 1 percent or lower does the ZLB engender significantly higher variability of output and inflation in these simulations. In summary, these studies find a 2 percent inflation target to be an adequate buffer against adverse effects arising from the ZLB.

The economic tumult of the past two years, with short-term interest rates near zero in most major industrial economies, has challenged this conclusion. As figure 1 shows, the global financial crisis and ensuing recession have driven many major central banks to cut their short-term policy rates effectively to zero; other central banks constrained by the ZLB include the Swedish Riksbank and the Swiss National Bank. Despite these aggressive monetary policy actions, and despite...