A notable achievement of macroeconomic policy in the last decade has been the sustained reduction of inflation rates in many of the industrial countries. It is widely acknowledged that these gains towards a potential eventual objective of price stability have led to declines in the average level of nominal interest rates. These events have prompted new interest in the implications of a low long-run trend in the rate of inflation, and the associated level of nominal interest rates, for both the business cycle and the conduct of monetary policy. One issue concerns the implications of a zero floor on nominal interest rates.

In Discussion Paper No. 1068, Bankim Chadha and Research Fellow Daniel Tsiddon examine the distribution of output around capacity when demand for money is a non-linear function of the nominal interest rate such that nominal interest rates cannot become negative. When fluctuations in output result primarily from disturbances to the money market, the variance of output is shown to be an increasing function of the trend inflation rate. When they result from disturbances to the goods market, the variance of output is a decreasing function of the trend inflation rate. When both disturbances are significant, there exists, in general, a critical non-zero trend inflation rate that minimises the variance of output. In contrast to existing literature, this analysis is robust to circumstances where an active, counter-cyclical, monetary policy is ineffective, and fits into both the (new) classical and the (new) Keynesian paradigms.

Inflation, Nominal Interest Rates and the Variability of Output
Bankim Chadha and Daniel Tsiddon