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The Zero Lower Bound, the Dual Mandate, and Unconventional Dynamics

This article examines monetary policy when it is constrained by the zero lower bound (ZLB) on the nominal interest rate. Our analysis uses a nonlinear New Keynesian model with technology and discount factor shocks that accounts for the expectational effects of falling to and remaining at the ZLB. Specifically, we investigate why technology shocks may have unconventional effects at the ZLB, what factors affect the likelihood of hitting the ZLB, and the tradeoffs a central bank faces under a dual mandate. We initially focus on the New Keynesian model without capital (Model 1) but then study the model with capital (Model 2). The advantage of including capital is that it introduces another mechanism for intertemporal substitution that strengthens the expectational effects of the ZLB. Three main findings emerge: (1) In Model 1, the output gap specification in the Taylor rule may reverse the effects of technology shocks at the ZLB; (2) When the central bank targets the steady-state output gap in Model 2, a positive technology shock at the ZLB leads to more pronounced unconventional dynamics than in Model 1; (3) In Model 1, the constrained linear solution provides a decent approximation of the nonlinear solution, but meaningful differences exist between the solutions in Model 2.

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