Economic Quarterly

Fall 1998

Staggered Price Setting and the Zero Bound on Nominal Interest Rates

Alexander L. Wolman

Does the zero bound on nominal interest rates constitute an argument against low inflation? The Federal Reserve implements monetary policy with nominal interest rates, which tend to be low when inflation is low. However, in an optimizing model with staggered price setting, the zero bound does not hinder real economic activity — and thus does not constitute an argument against low inflation — for two reasons. First, low nominal interest rates promote efficient money holdings, and second, even when the nominal interest rate is zero, the real interest rate can fall if the monetary authority can engineer temporarily higher expected inflation.

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