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Persistence and the Role of Exchange Rate and Interest Rate Inertia in Monetary Policy

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    Abstract

    In a general equilibrium model, this paper investigates the importance of the exchange rate and the interpretation of the observed inertia in the policy interest rate. We derive an optimizing macroeconomic model that features habit formation in the consumer's utility function and uses a hybrid New Keynesian Phillips curve with inflation inertia. As a consequence, aggregate demand and supply shocks will have a persistent effect on output and inflation. In this framework, we assess the performance of simple, and perhaps non-optimal, interest rate rules under different degrees of habit formation and inflation persistence. We conclude that a policy rule that responds to expected inflation, as well as to output and the exchange rate, is able to reduce output and inflation volatility in the face of aggregate demand and foreign inflation shocks. This result must be interpreted with caution, because, as is found in other studies, i) the reduction in volatility is marginal and ii) the Taylor-type policy rule assessed here may be a restrictive one and, as mentioned before, non-optimal. On the other hand, the gains from adopting an inertial interest rate rule are directly related to the degree of inflation persistence in the model. In particular, when the degree of inflation persistence is high, an inertial policy rule attenuates the impacts that supply shocks have on inflation and the interest rate.

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    Paper provided by Central Bank of Chile in its series Working Papers Central Bank of Chile with number 300.

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    Date of creation: Dec 2004
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    Handle: RePEc:chb:bcchwp:300

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    1. Richard Clarida, 2001. "The Empirics of Monetary Policy Rules in Open Economies," NBER Working Papers 8603, National Bureau of Economic Research, Inc.
    2. Michael Woodford, 1999. "Optimal monetary policy inertia," Proceedings, Federal Reserve Bank of San Francisco.
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    4. Margaret M. McConnell & Gabriel Perez Quiros, 1998. "Output fluctuations in the United States: what has changed since the early 1980s?," Staff Reports 41, Federal Reserve Bank of New York.
    5. Reinhart, Carmen & Calvo, Guillermo, 2002. "Fear of floating," MPRA Paper 14000, University Library of Munich, Germany.
    6. Fuhrer, Jeff & Moore, George, 1995. "Inflation Persistence," The Quarterly Journal of Economics, MIT Press, vol. 110(1), pages 127-59, February.
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    8. Richard Dennis, 2002. "Exploring the role of the real exchange rate in Australian monetary policy," Working Paper Series 2002-19, Federal Reserve Bank of San Francisco.
    9. Jeffrey C. Fuhrer, 2000. "Habit Formation in Consumption and Its Implications for Monetary-Policy Models," American Economic Review, American Economic Association, vol. 90(3), pages 367-390, June.
    10. Favero, Carlo A., 2001. "Applied Macroeconometrics," OUP Catalogue, Oxford University Press, number 9780198296850, September.
    11. Glenn D. Rudebusch, 2001. "Term structure evidence on interest rate smoothing and monetary policy inertia," Working Paper Series 2001-02, Federal Reserve Bank of San Francisco.
    12. Laurence Ball, 1998. "Policy Rules for Open Economies," RBA Research Discussion Papers rdp9806, Reserve Bank of Australia.
    13. Eiji Fujii & Menzie D. Chinn, 2000. "Fin de Siecle Real Interest Parity," NBER Working Papers 7880, National Bureau of Economic Research, Inc.
    14. Sack, Brian, 2000. "Does the fed act gradually? A VAR analysis," Journal of Monetary Economics, Elsevier, vol. 46(1), pages 229-256, August.
    15. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
    16. Eric Parrado, 2004. "Inflation Targeting and Exchange Rate Rules in an Open Economy," IMF Working Papers 04/21, International Monetary Fund.
    17. Klaus Schmidt-Hebbel & Alejandro M. Werner, 2002. "Inflation Targeting in Brazil, Chile, and Mexico: Performance, Credibility, and the Exchange Rate," JOURNAL OF LACEA ECONOMIA, LACEA - LATIN AMERICAN AND CARIBBEAN ECONOMIC ASSOCIATION.
    18. 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.
    19. Oscar Landerretche & Felipe Morandé & Klaus Schmidt-Hebbe, 1999. "Inflation Targets and Stabilization in Chile," Working Papers Central Bank of Chile 55, Central Bank of Chile.
    20. Francisco Gallego & Leonardo Hernández & Klaus Schmidt-Hebbel, 2002. "Capital Controls in Chile: Were They Effective?," Central Banking, Analysis, and Economic Policies Book Series, in: Leonardo Hernández & Klaus Schmidt-Hebbel & Norman Loayza (Series Editor) & Klaus Schmidt-Hebbel (S (ed.), Banking, Financial Integration, and International Crises, edition 1, volume 3, chapter 12, pages 361-412 Central Bank of Chile.
    21. Richard Dennis, 2000. "Optimal simple targeting rules for small open economies," Working Paper Series 2000-20, Federal Reserve Bank of San Francisco.
    22. Pablo García & Luis Óscar Herrera & Rodrigo O. Valdés, 2002. "New Frontiers for Monetary Policy in Chile," Central Banking, Analysis, and Economic Policies Book Series, in: Norman Loayza & Raimundo Soto & Norman Loayza (Series Editor) & Klaus Schmidt-Hebbel (Series Editor) (ed.), Inflation Targeting: Desing, Performance, Challenges, edition 1, volume 5, chapter 15, pages 627-649 Central Bank of Chile.
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