Accepted Manuscript

Conservatism and Liquidity Traps

Taisuke Nakata, Sebastian Schmidt

PII: S0304-3932(18)30558-0
DOI: https://doi.org/10.1016/j.jmoneco.2018.09.005
Reference: MONEC 3044

To appear in: Journal of Monetary Economics

Received date: 8 July 2015

Revised date: 12 September 2018
Accepted date: 21 September 2018

Please cite this article as: Taisuke Nakata, Sebastian Schmidt, Conservatism and Liquidity Traps,
Journal of Monetary Economics (2018), doi: https://doi.org/10.1016/j.jmoneco.2018.09.005

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 ACCEPTED MANUSCRIPT

1 Highlights

2 • We study optimal monetary policy when the zero lower bound is occasionally binding.

3 • Anticipation of future zero lower bound episodes creates a stabilization trade-off.

4 • In the discretionary equilibrium, inflation stays systematically below target.

5 • Appointment of an inflation conservative central banker enhances welfare.

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6 Conservatism and Liquidity Traps✩

7 Taisuke Nakataa,∗, Sebastian Schmidtb,∗∗

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a Board of Governors of the Federal Reserve System, Division of Research and Statistics, 20th Street and Constitution
9 Avenue N.W. Washington, D.C. 20551
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b European Central Bank, Monetary Policy Research Division, 60640 Frankfurt, Germany

September 22, 2018

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12 Abstract

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In an economy with an occasionally binding zero lower bound (ZLB) constraint, the anticipation of future

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ZLB episodes creates a trade-off for discretionary central banks between inflation and output stabilization. As

a consequence, inflation systematically falls below target even when the policy rate is above zero. Appointing

Rogoff’s (1985) conservative central banker mitigates this deflationary bias away from the ZLB and enhances

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welfare by improving allocations both at and away from the ZLB.
Keywords: Deflationary Bias, Inflation Conservatism, Inflation Targeting, Liquidity Traps, Zero Lower
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14 Bound

15 JEL: E31, E52, E61

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✩ We would like to thank an anonymous referee, Klaus Adam, Lena Boneva, Matthias Burgert, Yoichi Hizen, Keiichiro

Kobayashi, Ricardo Reis, John Roberts, Stephanie Schmitt-Grohe, Yuichiro Waki, Henning Weber, participants at the 2015
T2M conference, the XVII Inflation Targeting conference of the Banco Central do Brasil, the 11th Dynare conference, the
17th Annual Macro Conference at Hitotsubashi University, the XXIV International Rome Conference on Money, Banking and
Finance, the 7th Bundesbank-CFS-ECB Workshop on Macro and Finance, the 2017 CEF conference, the Central Bank of
Ireland conference on Macroeconomic Effects of Policy Announcements, and seminar participants at the European Central
Bank, the University of Hamburg, the University of Tokyo, the University of Kiel, the Swiss National Bank, the University of
Tuebingen, the Bank of Finland, and the DIW Berlin for comments. We would also like to thank Timothy Hills for his excellent
research assistance. The views expressed in this paper, and all errors and omissions, should be regarded as those solely of the
authors, and are not necessarily those of the Federal Reserve Board of Governors, the Federal Reserve System, or the European
Central Bank.
∗ Email: taisuke.nakata@frb.gov. Tel.: +1 2024522972.
∗∗ Email: sebastian.schmidt@ecb.int. Tel.: +49 6913448266.

Preprint submitted to Elsevier September 22, 2018

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16 1. Introduction

17 In light of the recent episode of subdued inflation rates and low nominal interest rates in many advanced

18 economies, an increasing number of economists and policymakers has called for a re-assessment of central

19 banks’ monetary policy frameworks.1 This paper contributes to this task by examining the desirability of

20 Rogoff’s (1985) inflation conservative central banker in an economy with an occasionally binding zero lower

21 bound (ZLB) on nominal interest rates.

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22 Rogoff (1985) considered a model where in the absence of a commitment device monetary stabilization

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23 policy suffers from a credibility problem that results in excessive inflation—the so-called inflation bias (Kyd-

24 land and Prescott, 1977; Barro and Gordon, 1983). He showed that in this environment society can be better

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25 off if the central bank is less concerned with output gap stability relative to inflation stability than is society.

26 The credibility problem of discretionary monetary policy at the ZLB is of the opposite nature: Expected

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inflation is too low and the inability of the central bank to increase inflation expectations further depresses

current inflation.2 We consider the latter credibility problem in a New Keynesian model where monetary

policy is delegated to a discretionary central bank which decides each period about the short-term policy
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30 rate. To focus on the role of the ZLB, we abstract from the original inflation bias problem. Society’s welfare

31 can then be approximated by the negative of the weighted sum of inflation and output volatility.
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32 In this model, the ZLB makes the first-best equilibrium unattainable and can lead to sizable output losses

33 and deflation.3 We find that the appointment of an inflation conservative central banker reduces the welfare

costs of discretionary policymaking induced by the ZLB. The mechanism behind our result is as follows. In
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34

35 an economy in which future shocks can push the policy rate to the lower bound, the anticipation of lower

36 inflation and output gives forward-looking households and firms incentives to reduce consumption and prices
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37 even when the policy rate is above the ZLB. The central bank cannot fully counteract these incentives. When

38 the central bank is concerned with both inflation and output stabilization, it faces a trade-off between the
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39 two objectives, implying deflation and a positive output gap in those states where the ZLB is not binding.

40 Following the terminology of Nakov (2008), we will refer to this deflation when the policy rate is above zero

41 as deflationary bias.
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42 A central banker who puts comparatively more weight on inflation stabilization mitigates the deflationary

43 bias away from the ZLB at the cost of a potentially higher output gap. Viewed in isolation, this is welfare-

44 reducing because it shifts inflation and output gap realizations away from the welfare-implied target criteria.

45 However, lower deflation and higher output gaps away from the ZLB also reduce expected real interest rates

1 See,for example, Blanchard et al. (2010); Tabellini (2014); Williams (2014, 2016).
2 See Krugman (1998) and Eggertsson (2006).
3 See Adam and Billi (2007).

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46 and increase expected marginal costs at the ZLB, mitigating deflation and output declines there. This in

47 turn implies that a smaller positive output gap is required to stabilize inflation away from the ZLB, setting

48 in motion a positive feedback loop.

49 We prove analytically the optimality of placing zero weight on output stabilization for our baseline

50 sticky-price model where the economy is only subject to a two-state natural real rate shock and we quantify

51 the welfare gains from inflation conservatism numerically in a more elaborate continuous-state model with

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52 additional shocks, nominal price and wage rigidities and endogenous inflation inertia. In the quantitative

model, the central bank’s optimal weight on output stabilization—while strictly smaller than society’s weight

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53

54 on output stabilization—is typically slightly above zero when we account for cost-push shocks. The welfare

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55 gains from inflation conservatism are non-negligible, and can be quite large, e.g. up to 90%, for reasonable

56 parameterizations.

57 The desirability of inflation conservatism in the presence of the ZLB is compared with several other

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institutional configurations that were originally studied in the context of the classic inflation bias problem

of discretionary policymaking.4 Imposing an optimized output or inflation target on the central bank, or
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60 assigning a simple linear contract that rewards the central bank for positive inflation rates or positive output

61 gaps also helps to reduce the welfare costs of discretionary policymaking induced by the ZLB. Depending

62 on the model variant, the gains from these alternative institutional arrangements may be larger than those
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63 from inflation conservatism. However, an appealing feature of inflation conservatism is its robustness. Con-

64 servatism is desirable both in the context of the deflationary bias problem considered here and in the context
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65 of the classical inflation bias problem. In contrast, the sign of the optimized target or contract parameter is

66 sensitive to whether the economy suffers from the deflationary bias or the inflation bias problem.

An additional contribution of our paper is to show that the ZLB makes discretionary monetary pol-
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67

68 icy prone to equilibrium multiplicity.5 In our baseline two-state model, there can be two Markov-Perfect

69 equilibria, and we provide analytical characterizations of the conditions for equilibrium existence.
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70 Our paper is related to a set of papers that examine various ways to improve allocations at the ZLB

71 in time-consistent manners. Eggertsson (2006), Burgert and Schmidt (2014), and Bhattarai et al. (2015)
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72 consider economies in which the government can choose the level of nominal debt and show that an increase in

73 government bonds during the liquidity trap improves allocations by creating incentives for future governments

74 to inflate. In a model in which government spending is valued by the household, Nakata (2016) and Schmidt

75 (2013) show that a temporary increase in government spending can improve welfare whenever the policy rate

4 See,e.g., Persson and Tabellini (1993), Walsh (1995), and Svensson (1997).
5 Seealso Armenter (2018) and Nakata (2018). The fact that the ZLB can give rise to equilibrium multiplicity was first
shown by Benhabib et al. (2001) in the context of simple monetary policy rules. They did not consider discretionary policy.

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76 is stuck at the ZLB. Schmidt (2017) examines the desirability of fiscal policy delegation regimes in the context

77 of the ZLB. He finds that a fiscal authority that is less concerned with government consumption stability

78 relative to output gap and inflation stability than society mitigates the time-inconsistency problem and

79 increases welfare. A key characteristic of these proposals is that they involve additional policy instruments

80 and require coordination of monetary and fiscal authorities. The approach studied in our paper only requires

81 that the central bank is maximizing its assigned objective.6

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82 Finally, our work is also related to a set of papers that examine the desirability of Rogoff’s conservative

central banker in settings other than the original model with inflation bias. Clarida et al. (1999) showed that

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84 the appointment of a conservative central banker is also desirable in a New Keynesian model, in which the

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85 presence of persistent cost-push shocks creates a stabilization bias in discretionary monetary policy—that is,

86 an inferior short-run trade-off between inflation and output stabilization compared with the time-inconsistent

87 Ramsey policy. Adam and Billi (2008), Adam and Billi (2014), and Niemann (2011) examined the benefit

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89 of these studies have abstracted from the ZLB constraint.

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of conservatism in versions of New Keynesian models augmented with endogenous fiscal policy. However, all
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90 Before closing the introduction, let us emphasize that the deflationary bias we analyze in this paper is

91 not a mere theoretical curiosity. In the United States, a country in which the key policy rate is no longer at

92 the lower bound, inflation hovered below the Federal Open Market Committee’s 2 percent inflation objective
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93 for a few years even after liftoff—which occurred in December 2015—and despite an unemployment rate

94 that has moved below most estimates of its natural rate. Some policymakers have argued that long-run
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95 inflation expectations may have moved down since the global financial crisis—citing survey and marked-

96 based measures of inflation expectations such as the 5-year, 5-year forward inflation expectation rate shown

in Figure 1—and that this decline in inflation expectations has contributed to the low inflation phenomenon
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98 (see Brainard, 2017, 2018). Our model provides one potential explanation for why inflation expectations are

99 subdued—the private sector’s anticipation that policy rates may get stuck at the lower bound again in the
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100 future—and is consistent with a configuration where inflation is below the central bank’s objective while the

101 economy operates close to or above potential.7

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102 The remainder of the paper is organized as follows. Section 2 describes the baseline model and the

103 government’s optimization problem, and defines the welfare measure. Section 3 presents the main results on

104 inflation conservatism. Section 4 compares inflation conservatism to other institutional configurations that

6 Some studies examine other time-consistent ways to better stabilize inflation and output in the model with the ZLB

constraint without relying on additional policy instruments. See Nakata (2018) for an approach based on reputation, and Billi
(2013) and Nakata and Schmidt (2016) for alternative monetary policy delegation schemes.
7 Brainard (2017) explicitly refers to higher perceived zero lower bound risk as one potential source of the decline in inflation

expectation indicators.

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105 aim to mitigate the credibility problem of discretionary monetary policy. Section 5 provides a quantitative

106 analysis of inflation conservatism based on a bigger continuous-state model. Section 6 concludes.

107 2. A simple model

108 This section presents the baseline model, lays down the policy problem of the central bank and defines

109 the equilibrium. The basic structure of this model is also at the heart of the more elaborate model that we

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110 use in our quantitative analyses.

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111 2.1. Private sector

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112 The private sector of the economy is given by the standard New Keynesian structure formulated in

113 discrete time with infinite horizon as developed in detail in Woodford (2003) and Gali (2008). Following

the majority of the literature on the ZLB, we put all model equations except for the ZLB constraint in

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114

115 semi-loglinear form. This allows us to derive closed-form results.

The equilibrium conditions of the private sector are given by the following two equations:
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πt = κyt + βEt πt+1 (1)

yt = Et yt+1 − σ (it − Et πt+1 − rtn ) , (2)

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116 where πt is the inflation rate between periods t − 1 and t, yt denotes the output gap, it is the level of the
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117 nominal interest rate between periods t and t + 1, and rtn is the exogenous natural real rate of interest.

118 Et is the rational expectations operator conditional on information available in period t. Equation (1) is a

standard New Keynesian Phillips curve and equation (2) is the consumption Euler equation. The parameters
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119

120 are defined as follows: β ∈ (0, 1) denotes the representative household’s subjective discount factor, σ > 0 is

121 the intertemporal elasticity of substitution in consumption, and κ represents the slope of the New Keynesian
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122 Phillips curve.8

We assume that the natural real rate follows a two-state Markov process. In particular, rtn takes the
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n n n n
value of either rH or rL where we refer to rH > 0 as the high (non-crisis) state and rL < 0 as the low (crisis)

(1−α)(1−αβ)

8κ is related to the structural parameters of the economy as follows: κ = α(1+ηθ)
σ −1 + η , where α ∈ (0, 1) denotes
the share of firms that cannot reoptimize their price in a given period, η > 0 is the inverse of the elasticity of labor supply, and
θ > 1 denotes the price elasticity of demand for differentiated goods.

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state. The transition probabilities are given by

n n n n
Prob(rt+1 = rL |rt = rH ) = pH (3)
n n n n
Prob(rt+1 = rL |rt = rL ) = pL . (4)

123 pH is the probability of moving to the low state in the next period when the economy is in the high state

today and will be referred to as the frequency of the contractionary shocks. pL is the probability of staying

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125 in the low state when the economy is in the low state today and will be referred to as the persistence of the

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126 contractionary shocks.

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127 2.2. Society’s objective and the central bank’s problem

128 We assume that society’s value, or welfare, at time t is given by the expected discounted sum of future

129 utility flows,

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Vt = u(πt , yt ) + βEt Vt+1 , (5)
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130 where society’s contemporaneous utility function, u(·, ·), is given by the standard quadratic function of

131 inflation and the output gap,

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1 2

u(π, y) = − π + λ̄y 2 . (6)
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132 This objective function can be motivated by a second-order approximation to the household’s preferences.

133 In such a case, λ̄ is a function of the structural parameters and is given by λ̄ = κθ .9

134 Monetary policy is delegated to a central bank. The value for the central bank is given by
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VtCB = uCB (πt , yt ) + βEt Vt+1

CB
, (7)
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135 where the central bank’s contemporaneous utility function, uCB (·, ·), is given by
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1 2

uCB (π, y) = − π + λy 2 . (8)
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136 Note that, while the central bank’s objective function resembles the private sector’s, the relative weight that

137 it attaches to the stabilization of the output gap, λ ≥ 0, may differ from λ̄. We assume that the central

138 bank does not have a commitment technology. Each period t, the central bank chooses the inflation rate,

9 See Woodford (2003).

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139 the output gap, and the nominal interest rate in order to maximize its objective function (7) subject to the

140 behavioral constraints of the private sector (1)-(2) and the ZLB constraint it ≥ 0, with the policy functions

141 at time t + 1 taken as given.

142 A Markov-Perfect equilibrium is defined as a set of time-invariant value and policy functions {V CB (·),

143 y(·), π(·), i(·)} that solves the central bank’s problem above, together with society’s value function V (·),

144 which is consistent with y(·) and π(·). As shown in the Online Appendix, there are two Markov-Perfect

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145 equilibria in this economy: One fluctuates around a positive nominal interest rate and zero inflation/output

(the standard Markov-Perfect equilibrium), and the other fluctuates around a zero nominal interest rate

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146

147 and negative inflation/output (the deflationary Markov-Perfect equilibrium). We focus on the standard

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148 Markov-Perfect equilibrium in this paper.

149 The main exercise of the next section will be to examine the effects of λ on society’s welfare. We quantify

150 the welfare of an economy by the equivalent perpetual consumption transfer (as a share of its steady state)

151

152 the economy,

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that would make a household in the hypothetical economy without any fluctuations indifferent to living in

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θ −1
W := (1 − β) σ + η E[V ], (9)
κ

153 where the mathematical expectation is taken with respect to the unconditional distribution of rtn .10
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154 3. Results
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155 After providing conditions for the existence of the standard Markov-Perfect equilibrium, this section

156 shows how output and inflation in the two states depend on the central bank’s relative weight on output

stabilization λ and shows that λ = 0 is optimal.

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158 Let xk denote the value of variable x in state k, where k ∈ {H, L}. The standard Markov-Perfect equi-

159 librium is then given by a vector {yH , πH , iH , yL , πL , iL } that satisfies the system of linear equations and
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160 inequality constraints described in the Online Appendix.

161
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Proposition 1: The standard Markov-Perfect equilibrium exists if and only if

pL ≤ p∗L (Θ(−pL ) ),

pH ≤ p∗H (Θ(−pH ) ),

10 For a derivation of the welfare-equivalent consumption transfer, see the Online Appendix.

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162 where i) for any parameter x, Θ(−x) denotes the set of parameter values excluding x, and ii) the cutoff values

163 p∗L (Θ(−pL ) ) and p∗H (Θ(−pH ) ) are given in the Online Appendix.

164

165 See the Online Appendix for the proof.11 For a given parameterization of the model (including the transition

166 probabilities for the two-state shock) the standard Markov-perfect equilibrium exists if and only if this

167 parameterization satisfies both inequality conditions.12

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When the conditions for the existence of the equilibrium hold, the allocations are given by

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βλpH n βκpH n κ2 + λ (1 − β(1 − pH )) n
πH = − rL , yH = rL , πL = − rL ,
E(λ) E(λ) E(λ)

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(1 − βpL )κ2 + (1 − β)(1 + βpH − βpL )λ n
yL = − rL ,
κE(λ)

1−pL


where E(λ) = βλpH − κ2 + (1 − β)λ σκ (1 − βpL + βpH ) − pL < 0. See the Online Appendix for the

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168

169 proof. The signs of these endogenous variables are unambiguously determined.

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171 Proposition 2: For any λ ≥ 0, πH ≤ 0, yH > 0, iH < rH , πL < 0, yL < 0, and iL = 0. With λ = 0,

172 πH = 0.

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174 See the Online Appendix for the proof. In the low state, the ZLB constraint becomes binding, and output

175 and inflation are below target. In the high state, a positive probability of entering the low state in the
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176 next period reduces expected marginal costs of production and leads firms to lower prices in anticipation of

177 future crises events. This raises the expected real rate faced by the representative household and gives it an
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178 incentive to postpone consumption. The central bank chooses to lower the nominal interest rate to mitigate

179 these anticipation effects. In equilibrium, inflation and output in the high state are negative and positive,

respectively, and the non-crisis policy rate is below the natural real interest rate. These analytical results
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180

181 are consistent with the numerical results in the literature (see Nakov (2008), among others). In particular,

182 negative inflation away from the ZLB has been referred to as deflationary bias. This proposition provides
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183 the first analytical underpinning for the deflation bias.

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184 Notice that the first part of this proposition (πH ≤ 0, yH > 0, and iH < rH ) can be seen as demonstrating

185 the breakdown of the so-called divine coincidence. If there were no ZLB constraint, then inflation and output

11 The conditions for the existence of the deflationary Markov-Perfect equilibrium turn out to be identical to those for the

existence of the standard Markov-Perfect equilibrium; see the Online Appendix

12 Richter and Throckmorton (2014) show numerically for a nonlinear New Keynesian model that the boundary of the region

of the parameter space where their solution algorithm converges to a minimum state variable solution imposes a trade-off
between the frequency and the persistence of ZLB events.

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186 gap in both states would be zero. Here, in the model with the ZLB constraint, inflation and the output gap

187 are not fully stabilized even in the high state when the ZLB does not bind. This is because the possibility of

188 future ZLB episodes reduces inflation expectations in the high state, which can be thought of as a negative

189 cost-push shock that shifts down the intercept of the Phillips curve. In this regard, accounting for pH > 0

190 is essential for the analysis.

191 We now establish several results on how the degree of conservatism affects endogenous variables in both

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192 states. In doing so, we assume that parameter values are such that the conditions for equilibrium hold for a

reasonable range of λ > 0.13

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193

194

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∂πH ∂yL ∂yH
195 Proposition 3: For any λ ≥ 0, < 0, ∂π
∂λ < 0, and
L
∂λ ∂λ < 0. For any λ ≥ 0, ∂λ < 0 if and only if


196 βpH − (1 − β) 1−p
κσ (1 − βpL + βpH ) − pL < 0.
L

197

198

199
See the Online Appendix for the proof. ∂πH
∂λ
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< 0 means that, as the central bank cares more about inflation,

inflation in the high state is higher (i.e., the deflation bias in the high state is smaller). Since a lower rate
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200 of deflation in the high state increases output and inflation in the low state via expectations, inflation and
∂yL
201 output in the low state both increase with the degree of conservatism ( ∂π
∂λ < 0 and
L
∂λ < 0). The effect of

202 conservatism on output in the high state is ambiguous. On the one hand, a more conservative central bank is
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203 willing to tolerate a larger overshooting of output given the same inflation expectations. On the other hand,

204 higher inflation in both states improves the trade-off between inflation and output stabilization implied by
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205 the Phillips curve, making it possible to reduce the overshooting of output in the non-crisis state.

206

Proposition 4: Suppose that pL and pH are sufficiently low so that pL ≤ p∗L (Θ(−pL ) ) and pH ≤ p∗H (Θ(−pH ) )
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207

208 for all λ in [0, λ̄]. Then, welfare is maximized at λ = 0.

209
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210 See the Online Appendix for the proof. As demonstrated in Proposition 3, deflation in the high state is smaller

211 and inflation and output decline less in the low state with a smaller λ. These forces work to improve society’s


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212 welfare. If βpH − (1 − β) 1−pκσ (1 − βpL + βpH ) − pL > 0, then output in the high state becomes smaller
L

213 with a smaller λ and the optimality of zero weight is obvious. If βpH −(1 − β) 1−p
κσ (1 − βpL + βpH ) − pL <
L

214 0, then a smaller λ increases the already positive output gap and thus has ambiguous effects on welfare.

215 Proposition 4 demonstrates that, even in this case, the beneficial effects of a smaller λ on πH , πL , and

216 yL dominate the adverse effect on yH . In the Online Appendix, we provide a numerical illustration of the

13 p∗ and p∗L do depend on λ, but for values of λ between 0 and λ̄ the quantitative effect is negligible.
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217 aforementioned model properties.

218 4. Other institutional solutions

219 In this section, we compare the optimal inflation conservative central banker with four other institutional

220 configurations that have been studied extensively in the context of the traditional inflation bias problem

221 of discretionary policy: a linear inflation/output gap contract (IC/OC), and an inflation/output gap target

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222 (IT/OT). To do so, we consider a modified version of the central bank’s period objective function

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1h 2 2
i
uCB (πt , yt ) = − (πt − fIT ) + λ̄ (yt − fOT ) + fIC πt + fOC yt , (10)
2

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223 where fIT , fOT , fIC and fOC are parameters, and where the weight on the quadratic output gap term in the

224 central bank’s objective function is the same as in society’s period utility function. Let j ∈ {IT, OT, IC, OC}

225

226
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denote a monetary policy regime that satisfies fj 6= 0 and fk = 0, ∀k ∈ {IT, OT, IC, OC}, k 6= j. The next

proposition shows that the regimes IT, OT, IC and OC are isomorphic to each other.
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227

228 Proposition 5: Suppose the policy parameter fj in regime j equals some value fˆ =
6 0. Then for each

229 monetary policy regime m ∈ {IT, OT, IC, OC}, m 6= j, there exists a value for policy parameter fm such
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230 that the equilibrium conditions under regimes j and m are the same.

231
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See the Online Appendix for the proof. Hence, welfare (9) is the same under the optimized IT, OT, IC and

OC regimes, provided that an equilibrium exists. Without loss of generality, we therefore focus on the linear

inflation contract for the remainder of this section and set fIT , fOT , fOC = 0. In the Online Appendix, we
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show that the conditions for existence of the standard Markov-Perfect equilibrium provided in the previous

section are sufficient for all fIC ∈ [0, f¯IC ), where f¯IC > −rL
n
is a function of structural parameters. In the
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standard Markov-Perfect equilibrium with an inflation contract,

1−pL
σκ (1 − βpL + βpH ) − pL 2 β λ̄pH n
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πH = − κ fIC − r ,
E(λ̄) E(λ̄) L


βpH − (1 − β) 1−p
σκ (1 − βpL + βpH ) − pL
L
βκpH n
yH = κfIC + r ,
E(λ̄) E(λ̄) L
1−pL
(1 − βpL + βpH ) + (1 − pL ) 2
σκ κ2 + λ̄(1 − β(1 − pH )) n
πL = − κ fIC − rL ,
E(λ̄) E(λ̄)


βpL − 1 − (1 − β) 1−p
σκ (1 − βpL + βpH ) − pL
L
(1 − βpL )κ2 + (1 − β)(1 + βpH − βpL )λ̄ n
yL = κfIC − rL ,
E(λ̄) κE(λ̄)

232 where E(·) is defined in Proposition 1. We can then establish the following welfare results.

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233

234
0
Proposition 6: (i) There exists a linear inflation contract with fIC = fIC 0
, where 0 < fIC < f¯IC , that repli-

235 cates the discretionary equilibrium under the optimal inflation conservative central banker. (ii) Welfare under

236 the optimal linear inflation contract is strictly larger than welfare under the optimal inflation-conservatism

237
∗
regime, and the optimized contract parameter fIC 0
satisfies fIC ∗
< fIC < f¯IC . (iii) The discretionary equi-

238 librium under the optimal linear inflation contract features strictly positive inflation in the high state, πH > 0.

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239

See the Online Appendix for the proof. Proposition 5 and Proposition 6 together imply that also the optimal

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240

241 IT, OT and OC regimes lead to better welfare outcomes than the optimal inflation-conservatism regime. A

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242 key feature of the optimal IT, OT, IC and OC regimes is that, unlike under the optimal conservatism regime

243 where inflation in the high state is zero, they stabilize inflation in the high state at a level strictly above

244 zero.14 Positive inflation in the high state mitigates the decline of output and inflation in the low state via

245

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expectations and consequently further improves the stabilization trade-off in the high state.15
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246 5. A quantitative model

247 In this section, we consider a more elaborate continuous-state model that allows us to quantify the welfare

effects of inflation conservatism and other institutional configurations in an empirically motivated framework.
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248

249 The model features price and wage rigidities as in Erceg et al. (2000), and non-reoptimized prices and wages

are partially indexed to past inflation. The economy is buffeted by preference shocks to the household’s
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250

251 discount factor that render the natural real rate of interest time-varying.16

5.1. The private sector and the central bank

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252

Aggregate private sector behavior is summarized by the following system of semi-loglinear equations

 
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γ
πt − τp πt−1 = κp yt + wt + β(Et πt+1 − τp πt ), (11)
1−γ
  
−1 η
πtW − τw πt−1 = κw σ + yt − wt + β(Et πt+1W
− τw πt ), (12)
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1−γ

πtW = wt − wt−1 + πt , (13)

yt = Et yt+1 − σ (it − Et πt+1 − rtn ) . (14)

14 The Online Appendix provides a numerical illustration.

15 Whether a marginal increase in fj raises or lowers output in the high state is determined by the same condition that
determines whether a marginal decrease in λ raises or lowers output in the high state under inflation conservatism.
16 The Online Appendix provides results for variants of the model where the economy is also buffeted by either price mark-up

shocks or wage mark-up shocks.

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Equation (11) captures the price setting behavior of firms, where wt is the composite real wage rate. Equation

(12) summarizes the nominal wage setting behavior of households, where πtW denotes nominal wage inflation

between periods t − 1 and t. Parameters τp and τw represent the degree of indexation of prices and wages

to past inflation. Equation (13) relates nominal wage inflation to the change in the real wage rate and

the price inflation rate, and equation (14) is the familiar consumption Euler equation. Parameters satisfy
(1−α)(1−αβ) 1−γ (1−αW )(1−βαW )
κp = α 1−γ+γθ , and κw = αW (1+ηθW ) , where γ ∈ (0, 1) is the capital elasticity of output,

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αW ∈ (0, 1) denotes the share of labor unions that cannot reoptimize the nominal wage in a given period and

θW > 1 is the wage elasticity of demand for differentiated labor services. The natural real rate of interest

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follows a stationary autoregressive process

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rtn = ρr rt−1
n
+ (1 − ρr ) rn + rt ,

253

254
where rt are i.i.d. N(0,σr2 ) innovations, and rn = 1/β − 1.
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As before, society’s welfare at time t is given by the expected discounted sum of future utility flows. In
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255 the quantitative model, society’s contemporaneous utility function u(·) is given by the following second-order

256 approximation to the household’s utility, assuming that deterministic steady state distortions are eliminated

257 by appropriate subsidies17

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1 
u(πt , yt , πtW , πt−1 , πt−1
W
)=− (πt − τp πt−1 )2 + λ̄yt2 + λ̄W (πtW − τw πt−1 ))2 , (15)
2
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258 where the relative weights are functions of the structural parameters.18

259 As before, the central bank acts under discretion. We consider four monetary policy regimes: the
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260 benchmark regime where the central bank has the same objective function as society, inflation conservatism,

261 a linear inflation contract and wage inflation conservatism. A wage inflation conservative central banker
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262 is a natural institutional reform candidate in our quantitative model since the presence of nominal wage

263 rigidities implies that society cares about wage inflation stability. Nesting these four regimes, the central

264 bank’s contemporaneous utility function u(·)CB is given by

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1 
uCB (πt , yt , πtW , πt−1 , πt−1
W
)=− λπ (πt − τp πt−1 )2 + λyt2 + λ̄W (πtW − τw πt−1 )2 + f πt , (16)
2

265 where λπ , λ and f are policy parameters. For λπ = 1, λ = λ̄ and f = 0, the central bank’s objective

17 See Giannoni and Woodford (2004).

 
(1−γ)θW
18 Specifically,λ̄ = κp σ −1 + η+γ 1
and λ̄W = λ̄ .
1−γ θ κw (σ −1 +(η+γ)/(1−γ))

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266 function collapses to society’s objective function. The formal optimization problem of a generic discretionary

267 policymaker is described in the Online Appendix.

268 5.2. Calibration and model solution

269 The values of the structural model parameters are listed in Table 1. The period length is one quarter. We

270 use standard values for parameters capturing preferences, technology, market power and nominal rigidities.19

271 The parameters ρr and σr of the natural real rate shock process are estimated using U.S. data for the period

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272 1984-Q1 to 2016-Q4, following the approach of Adam and Billi (2006). The implied values for the parameters

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273 in society’s objective function are λ̄ = 0.0037 and λ̄W = 2.0897. We use a projection method with finite

elements to solve the model numerically. This method allows for an accurate treatment of expectation

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274

275 terms. The details of the estimation procedure and the computational algorithm are described in the Online

276 Appendix.

277

278
5.3. Optimal institutional configurations
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As before, we quantify the effects of alternative monetary policy regimes on society’s welfare by the
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279 perpetual consumption transfer (as a share of its steady state) that would make a household in the artificial

280 economy without any fluctuations indifferent to living in the economy. In the quantitative model, this

welfare-equivalent consumption transfer is given by

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281

θ
W := (1 − β) E[V ]. (17)
κp
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282 Table 2 reports the optimized central bank objective function parameters, welfare as defined by equation

(17), the frequency and the average duration of ZLB episodes for the four alternative regimes.20 Under
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283

284 the benchmark regime, society’s welfare loss amounts to a permanent reduction in consumption of 0.49%

285 of its deterministic steady state. Without the ZLB constraint, the discretionary policymaker would be able
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286 to replicate the efficient allocation. Hence, welfare losses are directly linked to the presence of the ZLB

287 constraint. The ZLB binds in 25% of the simulated periods and the average duration of ZLB episodes is
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288 3.9 quarters. Under optimal inflation conservatism, the weight on output gap stabilization in the central

289 bank’s objective function is zero. Society’s welfare is 90% higher than under the benchmark regime. The

290 effect of inflation conservatism on the frequency of ZLB events is ambiguous. On the one hand, an inflation

291 conservative central banker responds more elastically to variations in inflation than the benchmark central

19 The indexation parameters for prices and nominal wages are set to 0.17 since for higher degrees of indexation convergence

of the solution algorithm fails under the discretionary benchmark regime.

20 Results are based on 2000 simulations with a length of 1200 periods each, where the first 200 periods are discarded as

burn-in periods. For each regime candidate, we calculate the average of the discounted welfare loss across the simulations.

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292 banker does since she is less concerned with fluctuations in the output gap. On the other hand, inflation

293 conservatism mitigates the deflationary bias in states where the natural real rate is low but strictly positive,

294 thereby ceteris paribus reducing the optimal amount of policy accommodation in these states. For our

295 baseline calibration, the second channel is slightly stronger than the first one, leading to a five percentage

296 points decrease in the frequency of ZLB events. This goes hand-in-hand with a slight reduction in the

297 average duration of ZLB episodes. The optimal linear inflation contract exhibits a strictly positive contract

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298 parameter f and leads to a slightly lower welfare level than the conservatism regime.21 Finally, to explore

the desirability of wage inflation conservatism, we fix the central bank’s relative weight on output gap

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299

300 stabilization at the optimized value and ask whether there are additional gains from assigning a weight on

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301 inflation stabilization λπ that deviates from the weight of unity in society’s objective. For the baseline model,

302 assigning a higher weight on the price inflation term in the central bank’s objective function is associated with

303 additional welfare gains.22 Such a regime can be characterized as price inflation conservative in the sense

304

305 than society does.23

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that it puts a higher weight on price inflation stability relative to wage inflation and output gap stability
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306 The Online Appendix provides an example of a temporary liquidity trap scenario and shows how the

307 choice of the monetary policy regime affects the behavior of the economy. The next section takes a closer

308 look at the size of the deflationary bias—and how it is affected by inflation conservatism—in the quantitative
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309 model.
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310 5.4. Deflationary bias

311 Figure 2 compares equilibrium responses of price and wage inflation to the natural real rate for the

312 benchmark regime and the inflation conservative regime. The other two state variables are kept constant
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313 at their average values under the respective regime. The thick vertical line indicates the steady state of

314 the natural real rate and the two thin vertical lines indicate the level of the natural real rate below which
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315 the ZLB constraint becomes binding under the respective regime. Under both monetary policy regimes, the

316 deflationary bias is decreasing in the natural real rate of interest. When the natural real rate is at 4%, i.e.
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317 at its steady state, there is a deflationary bias of about 60 basis points in price inflation and 50 basis points

318 in wage inflation under the benchmark regime. The bias increases by 30 basis points (price inflation) and

319 40 basis points (wage inflation) when the natural real rate is lowered to 1%. In contrast, under the inflation

320 conservative central banker the deflationary bias is essentially zero when the natural real rate is at steady

21 In the two variants of the model with mark-up shocks and no indexation, welfare under the optimal inflation contract is

slightly higher than under optimal inflation conservatism.

22 The optimal value for λ reported in Table 2 is a corner solution since we put an upper bound of 5 on the grid for λ .
π π
23 In the variant of the model with price mark-up shocks and no indexation it becomes optimal to set λ < 1.
π

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321 state. When the natural real rate falls to 1% the deflationary bias in price and wage inflation remains smaller

322 than 10 basis points. The less severe deflationary bias under the inflation conservative central banker, in

323 turn, lowers the threshold value for the natural real rate below which the ZLB constraint becomes binding,

324 relative to the central banker with the benchmark objective.

325 5.5. The persistence of the natural real rate shock

The persistence of the natural real rate has an important bearing on quantitative outcomes. This section

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327 therefore reports results of a robustness exercise regarding the degree of persistence in the natural real rate

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328 process. Figure 3 shows how the autoregressive parameter ρr affects welfare, the frequency of ZLB episodes

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329 and the average duration of ZLB episodes. When varying ρr , the standard deviation of the innovation is

330 adjusted such that the unconditional standard deviation of the natural real rate remains unchanged. Results

331 are shown for the benchmark regime and for the inflation conservative regime. For all considered values of ρr

332

333 central banker is zero. US

the optimal relative weight on output gap stabilization in the objective function of the inflation conservative
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334 Under both policy regimes, welfare is decreasing and the ZLB frequency and average duration are in-

335 creasing in ρr . The welfare gain from inflation conservatism, represented by the distance between the blue

336 dashed line and the black solid line in the left panel, is increasing in the persistence of the natural real
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337 rate shock. Finally, the middle and right panels illustrate that the appointment of an inflation conservative

338 central banker can either increase or decrease the frequency of ZLB episodes and their average duration, as
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339 discussed before.

340 6. Conclusion
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341 We have demonstrated, both analytically and numerically, that an economy that experiences occasional

ZLB episodes can improve welfare by appointing a conservative central banker who is more concerned with
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342

343 inflation stabilization relative to output stabilization than society is. In the absence of policy commitment,

344 optimal monetary policy suffers from a deflationary bias. Inflation stays below target even when the policy
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345 rate is positive because households and firms anticipate that the ZLB can be binding in the future. Subdued

346 inflation rates away from the ZLB in turn exacerbate the decline in output and inflation when the economy is

347 in a liquidity trap. A conservative central banker counteracts this vicious cycle by mitigating the deflationary

348 bias away from the ZLB, thereby improving stabilization outcomes at and away from the ZLB.

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349 References

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Table 1: Baseline calibration of quantitative model

Parameter Value Economic interpretation

β 0.99 Subjective discount factor
σ 2 Intertemporal elasticity of substitution in consumption
η 1.5 Inverse labor supply elasticity
θ 9 Price elasticity of demand
θW 9 Wage elasticity of labor demand
α 0.8 Share of firms per period keeping prices unchanged
α 0.8 Share of labor unions per period keeping wages unchanged

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γ 0.3 Capital elasticity of output
τp 0.17 Partial indexation of prices

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τw 0.17 Partial indexation of nominal wages
ρr 0.85 AR coefficient natural real rate
0.4
σr Standard deviation natural real rate shock

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100

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Table 2: Results for the quantitative model - baseline calibration

Regime Optimized policy Welfare ZLB frequency Av. ZLB duration

parameter (benchmark) in % in % in quarters
Benchmark discretion - -0.4855 25 3.9
Inflation conservatism λ = 0 (0.0037) -0.0484 20 3.3
Inflation contract f = 0.23 (0) -0.0602 15 2.9
Wage inflation conserv. λπ = 5 (1) -0.0362 19 3.2
Note: The welfare measure is defined in equation (17). The non-optimized policy parameters have the following values.

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Benchmark discretion: λπ = 1, λ = 0.0037, f = 0. Inflation conservatism: λπ = 1, f = 0. Inflation contract: λπ = 1,
λ = 0.0037. Wage inflation conservatism: λ = 0, f = 0.

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Figure 1: 5-year, 5-year forward inflation expectation rate

2.5

2
Percent

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1.5

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1

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0.5
01/2005 01/2007 01/2009 01/2011 01/2013 01/2015 01/2017 04/2018

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Source: Federal Reserve Bank of St. Louis; monthly frequency.
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Figure 2: Equilibrium responses to the natural real rate

Price inflation Wage inflation

0 0

-0.5
-0.5
-1

-1 -1.5

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-2

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-1.5

-2.5
-2

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Benchmark -3
Conservative

-2.5 -3.5
-5 0 5 10 -5 0 5 10
Natural real rate

US Natural real rate

Note: The figure shows equilibrium responses of price and wage inflation to the natural real rate of interest while holding the
lagged real wage rate and the lagged price inflation rate constant at their average values under the respective regime. All
variables are expressed in annualized percentages. The thick green vertical line indicates the steady state of the natural real
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rate. The thin black solid (blue dashed) vertical line indicates the level of the natural real rate below which the ZLB constraint
becomes binding under the discretionary benchmark regime (inflation conservative regime).
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Figure 3: Alternative degrees of natural real rate persistence

Welfare ZLB frequency (in %) Average ZLB duration (in quarters)

0 30 4

-0.1
25 3.5
-0.2
20 3
-0.3
15 2.5

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-0.4 Benchmark
Conservative
-0.5 10 2

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0.75 0.8 0.85 0.75 0.8 0.85 0.75 0.8 0.85
ρr ρr ρr

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Note: The welfare measure is defined in equation (17).

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