Central banks around the world try to influence economic activity by
altering nominal interest rates which will have an effect on the real
rate. However, this is only possible as long as interest rates are above
zero. The case of Japan showed that monetary policy was helpless as
nominal rates approached zero. This Book starts with an overview of
monetary policy with the restriction that interest rates can not fall
below zero. Then optimal monetary policy in a low inflation environment
is treated. This is done by using a New Keynesian model with sticky
prices. Therefore the model and the necessary optimality conditions will
be derived (this will be done extensively in the appendix). After
deriving the optimality conditions it will be shown how optimal monetary
policy will be conducted. To evaluate the outcome of monetary policy a
welfare function will be derived. It will be shown how the welfare
function to evaluate the outcome of monetary policy is derived from the
utility function of the household. As a result it will be shown that a
price level target is welfare maximizing although most central banks
nowadays use an inflation target instead. Reasons for an inflation
target will be shown in the discussion of the model. The second part of
the book describes the inflation dynamics in the euro area to see what
monetary authority shall do to prevent the economy from falling into the
vicious circle of deflation. Two wage contracting models that describe
inflation dynamics in the euro area reasonably well will be explained,
the Fuhrer-Moore und the Taylor contracting. After showing the optimal
policy it will be discussed how severe the zero bound in the euro area
is and what policy alternatives are left when monetary policy is
restricted. Finally the results obtained will be discussed to see the
pitfalls of price level targeting. The large appendix provides the
complete derivation of the model and the optimality conditions.
