Monetary policy rules and zero lower bound on nominal interest rates in a cost-channel economy

Abstract

This study analyzed monetary policy rules in a cost-channel economy with a zero lower bound on nominal interest rates (ZLB). The cost channel reflects the supply-side effects of the monetary policy. The ZLB is considered an occasionally binding constraint in a new Keynesian setting. Taylor-type interest rules represent the monetary policy rules, and the novel forward guidance rule introduced in this study is anticipated and endogenous. Under monetary policy rules, a cost-channel economy is more likely to fall into a liquidity trap and remain there longer than a no-cost-channel economy. Accordingly, monetary policy transmission differs from that in a no-cost-channel economy in the ZLB presence. Furthermore, if agents expect future recessions, achieving the inflation target is more challenging in cost-channel economies. Irrespective of the existence of a cost channel, the forward guidance rule reduces the frequency and depth of liquidity-trapped recessions compared to the Taylor-type rules and avoids deflation bias.