The stabilizing effect of the zero lower bound: A perspective of interest rate target zones

Abstract

This study first sets up a simple stochastic macro model embodying rational expectations, and then develops a graphical presentation to examine whether the zero lower bound (ZLB) tends to stabilize or destabilize relevant macroeconomic variables from the viewpoint of interest rate target zones. Within the standard IS−LM&AD−AS framework, this paper finds that in response to an increase in supply or demand shocks, the ZLB leads to a decline in the public’s inflation expectations. We also find that, when the economy experiences an aggregate supply shock, the ZLB will raise the variability of both prices and nominal interest rates, but reduce the variability of output. However, when the economy experiences a money demand shock, the ZLB tends to raise the variability of nominal interest rates, but reduce the variability of both prices and output.