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Interest Rate Stepping, Interest Rate Smoothing and Uncertainty: Some Views from the Literature

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  • W.H. Verhagen
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    Abstract

    This report analyses some of the reasons mentioned in the literature as to why central banks change interest rates at discrete intervals in the face of a continuously changing environment (interest rate stepping) and why they seem to prefer to implement changes in a series of small steps (interest rate smoothing). Despite the fact that both seem difficult to explain within the certainty equivalent optimal control framework frequently used to study monetary policy, it appears that modifying some of the assumptions of these models go a long way in explaining these phenomena. In particular, replacing the assumption that all uncertainty takes the form of additive shocks with known probability distributions with perhaps more realistic ways to model uncertainty will often yield stepping and smoothing as features of an optimal interest rate rule.

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    File URL: http://www.dnb.nl/binaries/wo0683_tcm46-145981.pdf
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    Bibliographic Info

    Paper provided by Netherlands Central Bank, Research Department in its series WO Research Memoranda (discontinued) with number 683.

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    Date of creation: 2002
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    Handle: RePEc:dnb:wormem:683

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    Keywords: Interest rate smoothing; uncertainty;

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    1. Svensson, Lars E.O., 1997. "Inflation Forecast Targeting: Implementing and Monitoring Inflation Targets," Seminar Papers 615, Stockholm University, Institute for International Economic Studies.
    2. D. Backus & J. Driffil, 1998. "Inflation and Reputation," Levine's Working Paper Archive 625, David K. Levine.
    3. Rudebusch, Glenn D., 1995. "Federal Reserve interest rate targeting, rational expectations, and the term structure," Journal of Monetary Economics, Elsevier, vol. 35(2), pages 245-274, April.
    4. Richard Clarida & Jordi Galí & Mark Gertler, 1997. "The science of monetary policy: A new Keynesian perspective," Economics Working Papers 356, Department of Economics and Business, Universitat Pompeu Fabra, revised Apr 1999.
    5. Peter von zur Muehlen, 2001. "Activist vs. non-activist monetary policy: optimal rules under extreme uncertainty," Finance and Economics Discussion Series 2001-02, Board of Governors of the Federal Reserve System (U.S.).
    6. Milton Friedman, 1971. "A Theoretical Framework for Monetary Analysis," NBER Books, National Bureau of Economic Research, Inc, number frie71-1, May.
    7. Woodford, M., 1999. "Optimal Monetary Policy Inertia.," Papers 666, Stockholm - International Economic Studies.
    8. Cukierman, Alex, 2001. "Are Contemporary Central Banks Transparent about Economic Models and Objectives and What Difference Does it Make?," Discussion Paper Series 1: Economic Studies 2001,05, Deutsche Bundesbank, Research Centre.
    9. Eijffinger, Sylvester C W & Schaling, Eric & Verhagen, Willem, 1999. "A Theory of Interest Rate Stepping: Inflation Targeting in a Dynamic Menu Cost Model," CEPR Discussion Papers 2168, C.E.P.R. Discussion Papers.
    10. Bennett T. McCallum, 1995. "Two Fallacies Concerning Central Bank Independence," NBER Working Papers 5075, National Bureau of Economic Research, Inc.
    11. 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.
    12. Sargent, Thomas J & Wallace, Neil, 1975. ""Rational" Expectations, the Optimal Monetary Instrument, and the Optimal Money Supply Rule," Journal of Political Economy, University of Chicago Press, vol. 83(2), pages 241-54, April.
    13. Barro, Robert J., 1986. "Reputation in a model of monetary policy with incomplete information," Journal of Monetary Economics, Elsevier, vol. 17(1), pages 3-20, January.
    14. Lucas, Robert Jr, 1976. "Econometric policy evaluation: A critique," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 1(1), pages 19-46, January.
    15. Goodfriend, Marvin, 1991. "Interest rates and the conduct of monetary policy," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 34(1), pages 7-30, January.
    16. Woodford, Michael, 1999. "Optimal monetary policy inertia," CFS Working Paper Series 1999/09, Center for Financial Studies (CFS).
    17. Charles Goodhart, 1998. "Central Bankers and Uncertainty," FMG Special Papers sp106, Financial Markets Group.
    18. Philip Lowe & Luci Ellis, 1997. "The Smoothing of Official Interest Rates," RBA Annual Conference Volume, in: Philip Lowe (ed.), Monetary Policy and Inflation Targeting Reserve Bank of Australia.
    19. Alan S. Blinder, 1999. "Central Banking in Theory and Practice," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262522608, December.
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