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Monetary policy inertia and the paradox of flexibility

Author

Listed:
  • Bonciani, Dario

    (Bank of England)

  • Oh, Joonseok

    (Freie Universität Berlin)

Abstract
This paper revisits the paradox of flexibility, ie, the result that, in a liquidity trap, greater price flexibility amplifies output volatility in response to negative demand shocks. We argue this paradox is the consequence of a failure of standard models to correctly characterise monetary policy and that allowing for a smooth adjustment of the shadow policy rate eliminates the paradox and produces output responses to a negative demand shock that are in line with those under optimal monetary policy. The reason is that, under an inertial policy, a decline in the shadow rate implies that the future actual policy rate will remain relatively low, which increases expectations about the economic outlook and inflation. The rise in inflation expectations reduces the real rate, thereby sustaining real activity. As we raise the degree of price flexibility, a negative demand shock causes a sharper fall in the shadow rate and increase in inflation expectations, which leads to a more significant drop in the real rate and, hence, a milder decline in the output gap.

Suggested Citation

  • Bonciani, Dario & Oh, Joonseok, 2020. "Monetary policy inertia and the paradox of flexibility," Bank of England working papers 888, Bank of England.
    • Handle: RePEc:boe:boeewp:0888
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    References listed on IDEAS

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    Cited by:

    1. Bonciani, Dario & Oh, Joonseok, 2023. "Revisiting the New Keynesian policy paradoxes under QE," European Economic Review, Elsevier, vol. 154(C).
    2. Eskelinen, Maria & Gibbs, Christopher G. & McClung, Nigel, 2024. "Resolving new keynesian puzzles," Bank of Finland Research Discussion Papers 5/2024, Bank of Finland.
    3. Bonciani, Dario & Oh, Joonseok, 2021. "Unemployment risk, liquidity traps and monetary policy," Bank of England working papers 920, Bank of England.

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    More about this item

    Keywords

    Interest rate smoothing; liquidity trap; zero lower bound; paradox of flexibility;
    All these keywords.

    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination

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