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Policy irreversibility and interest rate smoothing

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  • Kobayashi, Teruyoshi

Abstract

Many empirical studies argue that the inertial behavior of the policy rates in industrialized countries can be well explained by a linear partial adjustment version of the Taylor rule. However, the explanatory power of the lagged interest rate has been questioned from various points of view. This paper formally examines a situation in which a central bank has an aversion for frequent policy reversals. Imposing an irreversibility constraint on the control space makes the lagged interest rate a state variable, but the policy function cannot then be expressed as a partial adjustment form even if the original Taylor rule is the correct policy function in the absence of the constraint. The simulation results reveal that the conventional regression tends to falsely support the functionally misspecified partial adjustment model. This implies that the significant role of the lagged interest may simply reflect the central banks’ reversal aversion.

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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 19931.

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Date of creation: Jan 2010
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Handle: RePEc:pra:mprapa:19931

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Keywords: gradualism; interest rate smoothing; irreversibility; Taylor rule.;

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  1. Laurence Ball, 1997. "Efficient Rules for Monetary Policy," NBER Working Papers 5952, National Bureau of Economic Research, Inc.
  2. Ryo Kato & Shinichi Nishiyama, 2001. "Optimal Monetary Policy When Interest Rates are Bound at Zero," Working Papers 01-12, Ohio State University, Department of Economics.
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  12. Bharat Trehan & Tao Wu, 2004. "Time varying equilibrium real rates and monetary policy analysis," Working Paper Series 2004-10, Federal Reserve Bank of San Francisco.
  13. Gerlach-Kristen Petra, 2004. "Interest-Rate Smoothing: Monetary Policy Inertia or Unobserved Variables?," The B.E. Journal of Macroeconomics, De Gruyter, vol. 4(1), pages 1-19, March.
  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. Glenn D. Rudebusch, 2005. "Monetary policy inertia: fact or fiction?," Working Paper Series 2005-19, Federal Reserve Bank of San Francisco.
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