Working Paper No 606
By Martin Seneca
Large risk shocks give rise to cost-push effects in the canonical New Keynesian model. At the same time, monetary policy becomes less effective. Therefore, stochastic volatility introduces occasional trade-offs for monetary policy between inflation and output gap stabilisation. The cost-push effects operate through expectational responses to the interaction between shock volatility and the zero lower bound (ZLB) on interest rates. Optimal monetary policy calls for potentially sharp reductions in the interest rate when risk is elevated, even if this risk never materialises. Close to the ZLB, small risk shocks become ‘large’ in this sense. If policy is initially constrained by the ZLB, lift-off is optimally delayed when risk increases.