The effects of the near-zero interest rate policy in a regime-switching dynamic stochastic general equilibrium model

Abstract

Standard Dynamic Stochastic General Equilibrium (DSGE) models cannot explain the near-zero interest rate policy (near-ZIRP) by the Federal Reserve. I study two methods of modeling the near-ZIRP in DSGE models: the perfect foresight model and the Markov regime-switching model developed in this paper. The near-ZIRP has a significant expansionary effect, and the regime-switching model generates a more realistic predicted path of macro variables than the perfect foresight model. Furthermore, the government purchases multiplier in the near-ZIRP regime is smaller than what the literature finds at the zero lower bound (ZLB), and the contractionary effects of higher productivity found by the recent literature at the ZLB are not present in the regime-switching model.