Endogenous Volatility at the Zero Lower Bound: Implications for Stabilization Policy
At the zero lower bound, the central bank's inability to offset shocks endogenously generates volatility. In this setting, an increase in uncertainty about future shocks causes significant contractions in the economy and may lead to non-existence of an equilibrium. The form of the monetary policy rule is crucial for avoiding catastrophic outcomes. State-contingent optimal monetary and fiscal policies can attenuate this endogenous volatility by stabilizing the distribution of future outcomes. Fluctuations in uncertainty and the zero lower bound help our model match the unconditional and stochastic volatility in the recent macroeconomic data.
We thank Taisuke Nakata, Alexander Richter, Andrew Lee Smith, and Stephen Terry for helpful discussions, and Martin Eichenbaum and several anonymous referees for insightful comments. We also appreciate the feedback from participants at various conferences and seminars. We thank Daniel Molling for excellent research assistance and Research Automation for computational support. The views expressed herein are solely those of the authors and do not necessarily reflect the views of the Federal Reserve Bank of Kansas City, the Federal Reserve System, or the National Bureau of Economic Research.