What to Expect from the Lower Bound on Interest Rates: Evidence from Derivatives Prices
Thomas M. Mertens, John C. Williams
American Economic Review · 2021 · Volume 111 · Issue 8
Abstract
This paper analyzes the effects of the lower bound for interest rates on the distributions of inflation and interest rates. In a New Keynesian model with a lower bound, two equilibria emerge: policy is mostly unconstrained in the "target equilibrium," whereas policy is mostly constrained in the "liquidity trap equilibrium." Using options data on interest rates and inflation, we find forecast densities consistent with the target equilibrium and find no evidence in favor of the liquidity trap equilibrium. The lower bound has a sizable effect on the distribution of interest rates, but its impact on inflation is relatively modest.
Keywords
General Aggregative Models: Keynes, Keynesian, Post-Keynesian, Macroeconomics: Production, Price Level, Inflation, Deflation, Interest Rates: Determination, Term Structure, and Effects, Monetary Policy, Contingent Pricing, Futures Pricing, option pricing
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