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  4. August 2021
  5. What to Expect from the Lower Bound on Interest Rates: Evidence from Derivatives Prices

What to Expect from the Lower Bound on Interest Rates: Evidence from Derivatives Prices

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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.

Citation

Mertens, Thomas M., and John C. Williams. 2021. "What to Expect from the Lower Bound on Interest Rates: Evidence from Derivatives Prices." American Economic Review, 111 (8): 2473-2505. DOI: 10.1257/aer.20181461

Additional Materials

JEL Classification

  • E12 General Aggregative Models: Keynes; Keynesian; Post-Keynesian
  • E23 Macroeconomics: Production
  • E31 Price Level; Inflation; Deflation
  • E43 Interest Rates: Determination, Term Structure, and Effects
  • E52 Monetary Policy
  • G13 Contingent Pricing; Futures Pricing; option pricing