So what’s wrong with this pretty picture? Two ugly zeroes.
First is the zero lower bound on the interest rate: after a sufficiently large shock, the Taylor rule may say that you should keep cutting rates, but you can’t. Second is downward nominal rigidity, which isn’t quite as binding a constraint, but does lead the Phillips curve to be non-vertical in the face of very low inflation; as an IMF study of persistent large output gaps found, even years of a deeply depressed economy tend to produce at most slow, grinding deflation, and more usually slight positive inflation, not the ever-accelerating deflation the standard model would have predicted.
So here’s what happens after a large negative shock to the economy: the central bank finds itself up against the zero lower bound, so that all it can do is resort to controversial unorthodox measures. It might do that, or fiscal policy might be forced into action, if the economy really were suffering from accelerating deflation; but instead all you see is low inflation, which might even lead some central bankers to declare that they were doing their job just fine.
In the Bond movies, two zeroes meant a license to kill. In monetary policy, two zeroes — the hard zero on interest rates and the soft zero on wage changes — can, all too easily, give central bankers a de facto license to let the economy stagnate, remaining far below potential for an indefinite length of time.
Original memestarter blogpost.
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