“Are Nonlinear Methods Necessary at the Zero Lower Bound?“
with Alex Richter
FRB Dallas Working Paper 1606, November 2016

This paper examines the importance of using nonlinear methods to capture the zero lower bound (ZLB) on the Fed’s policy rate. While it may seem obvious to impose the ZLB, ex-ante it is unclear how large of an effect the ZLB has on parameter estimates, since it was only hit once in recent history. The parameters and marginal likelihoods from a linear and nonlinear model are similar, but the linear model does not fit the data as well and predicts counterfactually large policy shocks when the Fed is constrained. A quasi-linear model performs better than a linear model but it still generates less volatility at the ZLB and is not as conducive to estimation. When we add a banking sector to create an interest rate spread, the ZLB is even more important.