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Macroeconomic Implications of the Zero Lower Bound


What policies are effective at combatting recessions when the zero lower bound (ZLB) binds? This dissertations contributes to this question in at least three ways. First, it examines several such policies in a standard macroeconomic framework. Second, it uses extensive robustness checks as well as macroeconomic and financial data to validate or reject the key mechanisms that are at work in these models. Third, in the case of rejection, the standard framework is modified to match the data and this improved framework is used to re-evaluate the policies in question. This produces new insights relative to existing literature that has largely remained within the standard macroeconomic framework.

This dissertation first analyzes whether central banks should raise their inflation targets in light of the ZLB. It explicitly incorporates positive steady-state (or ``trend'') inflation in standard macroeconomic models as well as the ZLB on nominal interest rates. For plausible calibrations with costly but infrequent episodes at the zero-lower bound, the optimal inflation rate is low, typically less than two percent, even after considering a variety of extensions, including endogenous and state-dependent price stickiness and downward nominal wage rigidities. The key intuition behind this result is that the unconditional cost of the zero lower bound is small even though each individual ZLB event is quite costly. In short, raising the inflation target is too blunt an instrument to efficiently reduce the severe costs of zero-bound episodes.

Second, this dissertation considers whether fiscal policy be effective in an open economy with flexible exchange rates. Standard open economy models suggest that the open economy fiscal multiplier is small when exchange rates are flexible. This premise is reassessed by explicitly incorporating the ZLB on nominal interest rates in a small open economy New Keynesian model. It finds (1) when the ZLB binds and uncovered interest rate parity (UIP) holds, then the open economy fiscal multiplier is larger than 1 and bigger than the closed economy fiscal multiplier, (2) these conclusions can be reversed given significant violations of UIP, and (3) for estimated departures from UIP, the open economy fiscal multiplier at the ZLB is above 1 but smaller than the closed economy fiscal multiplier.

Third, this dissertation tests for a key propagation mechanism in standard macroeconomic models --- the inflation expectations channel. Accordingly, government spending multipliers are large and negative supply shocks are expansionary at the ZLB because they lower expected real interest rates, which stimulates consumption. The second prediction is tested with oil supply shocks, an earthquake, and inflation risk premia, demonstrating that negative supply shocks are contractionary at the ZLB despite also lowering expected real interest rates. These facts are rationalized in a model with financial frictions. In this model demand-side policies, such as fiscal stimulus through government spending, are substantially less effective at the ZLB than in standard sticky-price models, because raising inflation expectations by raising production costs is no longer a source of stimulus.

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