Uncertainty at the Zero Lower Bound
Federal Reserve BoardDecember 17, 2012
This paper examines how the presence of uncertainty alters allocations and prices when the nom-inal interest rate is constrained by the zero lower bound. I conduct the analysis using a standardNew Keynesian model in which the nominal interest rate is determined according to a truncatedTaylor rule. I ﬁnd that an increase in the variance of shocks to the discount factor process reducesconsumption, inﬂation, and output by a substantially larger amount when the zero lower bound isbinding than when it is not. Due to the zero lower bound constraint, policy functions for the realinterest rates and the marginal costs of production are highly convex and concave, respectively.As a result, a mean-preserving spread in the shock distribution increases the expectation of futurereal interest rates and decreases the expectation of future real marginal costs, which lead forward-looking households and ﬁrms to reduce consumption and set lower prices today. The more ﬂexibleprices are, the larger the eﬀects of uncertainty are at the zero lower bound.JEL: E32, E52, E61, E62, E63Keywords: Occasionally Binding Constraints, Liquidity Trap, Zero Lower Bound, Uncertainty.
I would like to thank Tim Cogley and Mark Gertler for their advice, and Christopher Erceg, John Roberts,Matt Smith, and Hiroatsu Tanaka for thoughtful comments. The views expressed in this paper, and all errors andomissions, should be regarded as those solely of the author, and are not necessarily those of the Federal ReserveBoard of Governors or the Federal Reserve System.
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