BoE paper offers solution to ‘paradox of flexibility’

Adding a shadow interest rate to a New Keynesian model can help avoid anomalies when a central bank faces a liquidity trap, a Bank of England working paper finds.

In Monetary policy inertia and the paradox of flexibility, Dario Bonciani and Joonseok Oh note standard models predict price flexibility is destabilising near the zero lower bound. If prices can adjust but monetary policy becomes powerless, this can trigger a deflationary spiral.

However, central banks in recent years have shown that