Monetary Policy, Incomplete Information, and the Zero Lower Bound

Abstract

In the context of a stylized New Keynesian model, we explore the interaction between imperfect knowledge about the state of the economy and the zero lower bound. We show that optimal policy under discretion near the zero lower bound responds to signals about an increase in the equilibrium real interest rate by less than it would when far from the zero lower bound. In addition, we show that Taylor-type rules that either include a time-varying intercept that moves with perceived changes in the equilibrium real rate or that respond aggressively to deviations of inflation and output from their target levels perform similarly to optimal discretionary policy. Our analysis of first-difference rules highlights that rules with interest rate smoothing terms carry forward current and past misperceptions about the state of the economy and can lead to suboptimal performance.