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Gains from interest-rate smoothing in a small open economy with zero-bound aversion

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  • Kam, Timothy
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    Abstract

    We extend the Monacelli [Monacelli, T. (2005). Monetary policy in a low pass-through environment. Journal of Money, Credit and Banking, 37(6), 1047-1066] model to allow for a central bank that penalizes nominal interest rate paths that are too close to the zero lower bound. We analytically derive the optimal interest-rate policy rule in each equilibrium under four policy regimes: (i) benchmark commitment to an ex-ante optimal monetary-policy plan; (ii) benchmark discretionary policy; (iii) optimal delegation to a discretionary policy maker with similar preferences to society; and (iv) optimal delegation to a discretionary policy maker with an additional taste for interest-rate smoothing. Under the commitment benchmark, the optimal interest-rate rule is proved to be intrinsically inertial, whereas this property is non-existent under discretionary policy. In the absence of commitment, there are gains to delegating policy to an interest-rate smoothing central banker. We show that while the endogenous law of one price gap in the model exacerbates the optimal policy trade-off that arises under discretionary policy, the latter feature of interest-rate smoothing acts to weaken it, by mimicking intrinsic inertia under the commitment policy.

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    Bibliographic Info

    Article provided by Elsevier in its journal The North American Journal of Economics and Finance.

    Volume (Year): 20 (2009)
    Issue (Month): 1 (March)
    Pages: 24-45

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    Handle: RePEc:eee:ecofin:v:20:y:2009:i:1:p:24-45

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    Web page: http://www.elsevier.com/locate/inca/620163

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    Keywords: Optimal monetary policy Zero-bound aversion Small open economy Stabilization bias;

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    1. Woodford, Michael, 1999. "Optimal Monetary Policy Inertia," Manchester School, University of Manchester, vol. 67(0), pages 1-35, Supplemen.
    2. Jensen, Henrik, 1999. "Targeting Nominal Income Growth or Inflation?," CEPR Discussion Papers 2341, C.E.P.R. Discussion Papers.
    3. Woodford, Michael, 1999. "Optimal monetary policy inertia," CFS Working Paper Series 1999/09, Center for Financial Studies (CFS).
    4. Jeffery D. Amato & Thomas Laubach, 2002. "Rule-of-thumb behaviour and monetary policy," Finance and Economics Discussion Series 2002-5, Board of Governors of the Federal Reserve System (U.S.).
    5. Mark Gertler & Jordi Gali & Richard Clarida, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," Journal of Economic Literature, American Economic Association, vol. 37(4), pages 1661-1707, December.
    6. Klaus Adam & Roberto M. Billi, 2005. "Optimal monetary policy under commitment with a zero bound on nominal interest rates," Research Working Paper RWP 05-07, Federal Reserve Bank of Kansas City.
    7. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
    8. Adam, Klaus & Billi, Roberto M., 2007. "Discretionary monetary policy and the zero lower bound on nominal interest rates," Journal of Monetary Economics, Elsevier, vol. 54(3), pages 728-752, April.
    9. Jordi Gali & Tommaso Monacelli, 2002. "Monetary Policy and Exchange Rate Volatility in a Small Open Economy," NBER Working Papers 8905, National Bureau of Economic Research, Inc.
    10. Alessandro Rebucci & Marco A Espinosa-Vega, 2003. "Retail Bank Interest Rate Pass-Through," IMF Working Papers 03/112, International Monetary Fund.
    11. Richard Clarida & Jordi Gali & Mark Gertler, 2001. "Optimal Monetary Policy in Open versus Closed Economies: An Integrated Approach," American Economic Review, American Economic Association, vol. 91(2), pages 248-252, May.
    12. Rogoff, Kenneth, 1985. "The Optimal Degree of Commitment to an Intermediate Monetary Target," The Quarterly Journal of Economics, MIT Press, vol. 100(4), pages 1169-89, November.
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