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International Finance Discussion Papers
The International Finance Discussion Papers logo links to the International Finance Discussion Papers home page Imperfect Credibility and the Zero Lower Bound on the Nominal Interest Rate
Martin Bodenstein, James Hebden, and Ricardo Nunes
2010-1001  (June 2010)

Abstract:  When the nominal interest rate reaches its zero lower bound, credibility is crucial for conducting forward guidance. We determine optimal policy in a New Keynesian model when the central bank has imperfect credibility and cannot set the nominal interest rate below zero. In our model, an announcement of a low interest rate for an extended period does not necessarily reflect high credibility. Even if the central bank does not face a temptation to act discretionarily in the current period, policy commitments should not be postponed. In reality, central banks are often reluctant to allow a recovery path with output and inflation temporarily above target. From the perspective of our model such a policy reflects a low degree of credibility. We find increased forecast uncertainty in inflation and the output gap at the zero lower bound while interest rate uncertainty is reduced. Furthermore, misalignments between announced interest rate paths and market expectations are found to be best explained by lack of credibility.

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Monetary policy, zero interest rate bound, commitment, liquidity trap

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Last update: July 16, 2010