Essays on the Cost Channel of Monetary Policy in the Presence of the Zero Lower Bound on Nominal Interest Rates

This thesis examines how differently various monetary policy strategies affect macroeconomic conditions in the presence of the zero lower bound on nominal interest rates (ZLB) when monetary policy has supply-side effects. The supply-side effect of monetary policy is generally considered as transmitted through the cost channel of monetary policy. This thesis consists of three independent but related studies.In the first study, I examine the robustness of an unconventional monetary policy in a cost channel economy. This unconventional policy, proposed by Schmitt-Grohe and Uribe (2017, American Economic Journal: Macroeconomics, SGU henceforth), recommends a tight monetary policy during a liquidity-trapped recession to stimulate the economy and to avoid jobless recovery. The results of my study show that the existence of the cost channel implies that the SGU policy induces sharp initial contractions in the employment rate and the growth rate, and a sharp increase in inflation following a negative confidence shock. Welfare is lower in cost channel economies compared to no-cost channel economies due to the SGU policy recommendation. Two alternative interest rate-based exit policies are also examined. The Overshoot interest rate policy, irrespective of the presence of the cost channel, is superior to the SGU policy with regard to welfare. The Staggered policy has lower immediate pain in the cost channel economy compared to the SGU policy or the Overshoot policy. However, welfare-wise, the Staggered policy is inferior to the other two policies examined in both economies considered. In the second study, I analyse optimal monetary policy, both under discretion and under commitment, in a cost channel economy in the presence of the ZLB. I use a variation of the standard New Keynesian model. Under discretionary policy, it was found that central banks needed to keep interest rates at the zero lower bound for longer in a cost channel economy compared to a no-cost channel economy. Under commitment policy, the simulation exercise shows that the central bank is able to terminate the zero interest rate regime earlier in a cost channel economy than in a no-cost channel economy. It was also revealed that the cost channel generates significantly higher welfare losses especially under discretionary policy. Accordingly, abstracting the cost channel in these type of models can lead to under estimation of welfare losses.In the third study, I evaluate interest rate rules at the ZLB in a cost channel economy. In addition, an endogenous threshold-based forward guidance (FG) policy rule is examined. Under Taylor-type truncated rules (TTR), first, the cost channel economy is more likely to fall into a liquidity trap and remain longer compared to the no-cost channel economy. Second, the risky steady state of a cost channel economy has more deflation bias than a no-cost channel economy. Third, the welfare loss is higher when uncertainty is high and it is appreciably higher in cost channel economies. Under the FG rule, compared to the TTR, the following results hold, irrespective of the cost channel: First, an appropriate FG rule can avoid deflation bias while strict FG leads to an inflation bias. Second, the FG rule reduces the frequency of liquidity-trapped recessions. Third, the depth of the recession under the FG rule is lower. The existence of the cost channel amplifies the inflation bias under the FG rule.Accordingly, all five monetary policy strategies considered in the three studies in this thesis affect the economy differently when the cost channel of monetary policy exists in the presence of the ZLB. Importantly, a liquidity-trapped recession is deeper in cost channel economies. These findings suggest that if a cost channel is present in an economy, the transmission of monetary policy may be different from that in a no-cost channel economy in the presence of the ZLB. Therefore, central banks should pay careful attention to the cost channel of monetary policy when they set policies under such economic conditions.