Optimal monetary policy inertia

  • This paper considers the desirability of the observed tendency of central banks to adjust interest rates only gradually in response to changes in economic conditions. It shows, in the context of a simple model of optimizing private-sector behavior, that such inertial behavior on the part of the central bank may indeed be optimal, in the sense of minimizing a loss function that penalizes inflation variations, deviations of output from potential, and interest-rate variability. Sluggish adjustment characterizes an optimal policy commitment, even though no such inertia would be present in the case of a reputationless (Markovian) equilibrium under discretion. Optimal interest-rate feedback rules are also characterized, and shown to involve substantial positive coefficients on lagged interest rates. This provides a theoretical explanation for the numerical results obtained by Rotemberg and Woodford (1998) in their quantitative model of the U.S. economy.

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Author:Michael Woodford
Parent Title (German):Institut für Kapitalmarktforschung (Frankfurt am Main): CFS working paper series ; No. 1999,09
Series (Serial Number):CFS working paper series (1999, 09)
Publisher:Inst. für Kapitalmarktforschung
Place of publication:Frankfurt am Main
Document Type:Working Paper
Year of Completion:1999
Year of first Publication:1999
Publishing Institution:Universitätsbibliothek Johann Christian Senckenberg
Release Date:2005/06/13
Tag:commitment; gradualism; interest-rate rules; monetary policy
GND Keyword:Geldpolitik; Hochzinspolitik; Zinspolitik; Regelbindung; Lag; Distributed lag; Optimierung; Wohlfahrtseffekt
Issue:Version March 31, 1999
Page Number:107
Source:CFS working paper ; 1999,09
Institutes:Wissenschaftliche Zentren und koordinierte Programme / Center for Financial Studies (CFS)
Dewey Decimal Classification:3 Sozialwissenschaften / 33 Wirtschaft / 330 Wirtschaft
Licence (German):License LogoDeutsches Urheberrecht