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Inflation and interest rates in the presence of a cost channel, wealth effect and agent heterogeneity

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  • Ali, Syed Zahid
  • Anwar, Sajid

Abstract

As far as the control of inflation is concerned, the interest rate is the most important monetary instrument. This paper examines the effectiveness of the interest rate policy in controlling inflation. The model utilized in this paper considers both demand and supply side effects of interest rate policy. These effects are used to derive not only the relevant impulse response functions but also the welfare loss to the society that arises from the supply side shocks. Based on their ability to control inflation and minimization of the overall welfare loss to the society, three policies are compared: (i) monetary policy with commitment, (ii) Taylor's rule, and (iii) inflation targeting. We argue that, in the presence of a cost channel, it is imperative that the interest rate policy is used with restraint. Our results also suggest that ignoring the cost channel of monetary policy can lead to significant under-estimation of the social welfare loss.

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Bibliographic Info

Article provided by Elsevier in its journal Economic Modelling.

Volume (Year): 31 (2013)
Issue (Month): C ()
Pages: 286-296

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Handle: RePEc:eee:ecmode:v:31:y:2013:i:c:p:286-296

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Web page: http://www.elsevier.com/locate/inca/30411

Related research

Keywords: Inflation targeting; Interest rate policy; Monetary commitment; Taylor's rule; Cost channel; Wealth effect; Agent heterogeneity;

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Cited by:
  1. Tuan Anh Phan, 2014. "Output Composition of the Monetary Policy Transmission Mechanism: Is Australia Different?," Crawford School Research Papers 1403, Crawford School of Public Policy, The Australian National University.

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