How to exit from zero interest rate when there is a financial accelerator

Abstract

This paper extends a simple new Keynesian DSGE model with a financial accelerator (FA) to study an exit strategy from zero interest rate. The extension of the model is made in two steps to consider the role of uncertainty explicitly: first introducing the FA mechanism that amplifies a shock and then investigating the financial shock uncertainty. The FA mechanism makes monetary policy to be less aggressive under the optimal discretionary policy regime. The introduction of the financial shock uncertainty however overwhelms the FA effect and makes monetary policy to be more aggressive in total. As a whole, the zero interest rate period is prolonged against the negative demand shock and the overshooting of output and inflation gaps are allowed during the phase of recovery. However, when the interest rate exits from the zero interest rate, it should be raised more steeply to a higher level than in the case of Nakov (2008) when the economy recovers.