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A case for interest rate smoothing

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  • Bask, Mikael

    ()
    (Bank of Finland Research)

Abstract

The aim of this paper is to determine whether it would be desirable from the perspective of macroeconomic balance for central banks to take account of nominal exchange rate movements when framing monetary policy. The theoretical framework is a small, open DSGE economy that is closed by a Taylor rule for the monetary authority, and a determinate REE that is least-squares learnable is defined as a desirable outcome in the economy. When the policy rule contains contemporaneous data on the output gap and the CPI inflation rate, the monetary authority does not have to consider the exchange rate as long as there is sufficient inertia in policy-making. In fact, due to a parity condition on the international asset market, interest rate smoothing and a response to changes in the nominal exchange rate are perfectly intersubstitutable in monetary policy. In other words, we give a rationale for the monetary authority to focus on the change in the nominal interest rate rather than its level in policy-making. Thus, we have a case for interest rate smoothing.

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File URL: http://www.suomenpankki.fi/en/julkaisut/tutkimukset/keskustelualoitteet/Documents/0725netti.pdf
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Bibliographic Info

Paper provided by Bank of Finland in its series Research Discussion Papers with number 25/2007.

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Length: 25 pages
Date of creation: 19 Dec 2007
Date of revision:
Handle: RePEc:hhs:bofrdp:2007_025

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Postal: Bank of Finland, P.O. Box 160, FI-00101 Helsinki, Finland
Web page: http://www.suomenpankki.fi/en/
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Keywords: determinacy; E-stability; foreign exchange; inertia; Taylor rule;

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  1. Luis-Gonzalo Llosa & Vicente Tuesta, 2008. "Determinacy and Learnability of Monetary Policy Rules in Small Open Economies," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 40(5), pages 1033-1063, 08.
  2. James Bullard & Kaushik Mitra, 2007. "Determinacy, Learnability, and Monetary Policy Inertia," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 39(5), pages 1177-1212, 08.
  3. Clarida, Richard & Galí, Jordi & Gertler, Mark, 1998. "Monetary Policy Rules and Macroeconomic Stability: Evidence and Some Theory," CEPR Discussion Papers 1908, C.E.P.R. Discussion Papers.
  4. Jordi Gal� & Tommaso Monacelli, 2005. "Monetary Policy and Exchange Rate Volatility in a Small Open Economy," Review of Economic Studies, Oxford University Press, vol. 72(3), pages 707-734.
  5. James Bullard & Kaushik Mitra, 2002. "Learning about monetary policy rules," Working Papers 2000-001, Federal Reserve Bank of St. Louis.
  6. John B. Taylor, 2001. "The Role of the Exchange Rate in Monetary-Policy Rules," American Economic Review, American Economic Association, vol. 91(2), pages 263-267, May.
  7. Thomas Lubik & Frank Schorfheide, 2003. "Do Central Banks Respond to Exchange Rate Movements? A Structural Investigation," Economics Working Paper Archive 505, The Johns Hopkins University,Department of Economics.
  8. Glenn D. Rudebusch, 1995. "Federal Reserve interest rate targeting, rational expectations, and the term structure," Working Papers in Applied Economic Theory 95-02, Federal Reserve Bank of San Francisco.
  9. Bennett T. McCallum, 2006. "E-Stability vis-a-vis Determinacy Results for a Broad Class of Linear Rational Expectations Models," NBER Working Papers 12441, National Bureau of Economic Research, Inc.
  10. Blanchard, Olivier Jean & Kahn, Charles M, 1980. "The Solution of Linear Difference Models under Rational Expectations," Econometrica, Econometric Society, vol. 48(5), pages 1305-11, July.
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