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Designing instrument rules for monetary stability: the optimality of interest-rate smoothing

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  • Rotondi, Zeno
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    Abstract

    A key issue in monetary policy is that on the importance of following systematic behaviours. The paper revisits the classic debate on rules versus discretion focusing on the design of instrument rules in a manner that push discretionary policy choices in the direction of the commitment equilibrium. It is shown that an instrument rule with an optimal degree of monetary inertia may render negligible the inflationary bias associated with discretion without necessarily implying a trade-off between flexibility and commitment. The rationale for this surprising finding is found in the disciplining effect played by interest-rate smoothing on the incentive to create surprise inflation by reducing suddenly the interest rate within the time horizon of existing nominal contracts. If the degree of gradualism is high it may enhance the credibility of optimal monetary policy as it contrasts the incentive to fool private sector. Keywords; monetary policy, instrument rules, commitment, discretion, interest-rate smoothing, delegation JEL classification: E52, E58

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    File URL: http://eprints.soton.ac.uk/33112/1/0008.pdf
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    Bibliographic Info

    Paper provided by Economics Division, School of Social Sciences, University of Southampton in its series Discussion Paper Series In Economics And Econometrics with number 0008.

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    Date of creation: 01 Jan 2000
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    Handle: RePEc:stn:sotoec:0008

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    1. 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.
    2. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 195-214, December.
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    4. Barro, Robert J & Gordon, David B, 1983. "A Positive Theory of Monetary Policy in a Natural Rate Model," Journal of Political Economy, University of Chicago Press, vol. 91(4), pages 589-610, August.
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    7. Robert E. Hall & N. Gregory Mankiw, 1994. "Nominal Income Targeting," NBER Working Papers 4439, National Bureau of Economic Research, Inc.
    8. Clark, Peter B. & Goodhart, Charles A. E. & Huang, Haizhou, 1999. "Optimal monetary policy rules in a rational expectations model of the Phillips curve," Journal of Monetary Economics, Elsevier, vol. 43(2), pages 497-520, April.
    9. Persson, Torsten & Tabellini, Guido, 1993. "Designing institutions for monetary stability," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 53-84, December.
    10. Cukierman, Alex & Meltzer, Allan H, 1986. "A Theory of Ambiguity, Credibility, and Inflation under Discretion and Asymmetric Information," Econometrica, Econometric Society, vol. 54(5), pages 1099-1128, September.
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    12. Al-Nowaihi, A & Levine, Paul L, 1996. "Independent but Accountable: Walsh Contracts and the Credibility Problem," CEPR Discussion Papers 1387, C.E.P.R. Discussion Papers.
    13. Alex Cukierman, 1992. "Central Bank Strategy, Credibility, and Independence: Theory and Evidence," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262031981, January.
    14. Lockwood, Ben & Miller, Marcus & Zhang, Lei, 1998. "Designing Monetary Policy When Unemployment Persists," Economica, London School of Economics and Political Science, vol. 65(259), pages 327-45, August.
    15. Letterie, Wilko, 1997. " Better Monetary Control May Decrease the Distortion of Stabilisation Policy: A Comment," Scandinavian Journal of Economics, Wiley Blackwell, vol. 99(3), pages 463-70, September.
    16. McCallum, Bennett T., 1993. "Discretion versus policy rules in practice: two critical points : A comment," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 215-220, December.
    17. Walsh, Carl E, 1995. "Optimal Contracts for Central Bankers," American Economic Review, American Economic Association, vol. 85(1), pages 150-67, March.
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