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A Reassessment of the Problems with Interest Targeting: What Have We Learned from Japanese Monetary Policy?

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  • Tom Cargill

    ()
    (Department of Economics, University of Nevada, Reno)

  • Federico Guerrero

    ()
    (Department of Economics, University of Nevada, Reno)

Abstract

Interest rate targeting is widely used by central banks to pursue price stability; however, the variation in inflation policy outcomes between central banks such as the Federal Reserve and the Bank of Japan despite a common policy instrument framework suggests interest- targeting has limitations. Despite the variation in policy outcomes, the role of targeting was enhanced with the advent of Taylor rules in the 1990s and interest rate targeting dominates central bank attitudes to the exclusion of any other policy instrument framework. The recent Japanese experience confronts us with the need to reassess the relative merits of interest targeting. This paper frames the discussion of the various problems of the interest-targeting framework within a model that encompasses a number of important previous results and stresses that interest rate targeting may leave the price level indeterminate in various plausible circumstances. In a low, or even zero interest rate environment, such as the one that characterized Japan, Taylor-type rules may offer no solution to the indeterminacy problem. The paper then discusses various aspects of the BoJ’s decision to adhere to interest rate targeting despite its limitations.

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File URL: http://www.business.unr.edu/econ/wp/papers/UNRECONWP06010.pdf
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Bibliographic Info

Paper provided by University of Nevada, Reno, Department of Economics & University of Nevada, Reno , Department of Resource Economics in its series Working Papers with number 06-010.

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Length: 30 pages
Date of creation: Dec 2006
Date of revision:
Handle: RePEc:unr:wpaper:06-010

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Keywords: Interest-targeting; Monetary Policy; Deflation; Japan;

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  1. Paul R. Krugman, 1998. "It's Baaack: Japan's Slump and the Return of the Liquidity Trap," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 29(2), pages 137-206.
  2. S. Rao Aiyagari, 1990. "Deflating the case for zero inflation," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Sum, pages 2-11.
  3. S. Rao Aiyagari, 1991. "Response to a defense of zero inflation," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Spr, pages 21-24.
  4. Iwamoto, Yasushi, 2005. "Monetary and Fiscal Policy to Escape from a Deflationary Trap," Monetary and Economic Studies, Institute for Monetary and Economic Studies, Bank of Japan, vol. 23(1), pages 1-46, February.
  5. Takatoshi Ito, 2004. "Inflation Targeting and Japan: Why has the Bank of Japan not Adopted Inflation Targeting?," RBA Annual Conference Volume, in: Christopher Kent & Simon Guttmann (ed.), The Future of Inflation Targeting Reserve Bank of Australia.
  6. Kenneth N. Kuttner & Adam S. Posen, 2003. "The Difficulty of Discerning What's Too Tight: Taylor Rules and Japanese Monetary Policy," Working Paper Series WP03-10, Peterson Institute for International Economics.
  7. Thomas F. Cargill, 2005. "Is the Bank of Japan's Financial Structure an Obstacle to Policy?," IMF Staff Papers, Palgrave Macmillan, vol. 52(2), pages 311-334, September.
  8. 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.
  9. Gauti B. Eggertsson & Michael Woodford, 2003. "The Zero Bound on Interest Rates and Optimal Monetary Policy," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 34(1), pages 139-235.
  10. Michael Dotsey, 1986. "Japanese monetary policy, a comparative analysis," Economic Review, Federal Reserve Bank of Richmond, issue Nov, pages 12-24.
  11. Feenstra, Robert C., 1986. "Functional equivalence between liquidity costs and the utility of money," Journal of Monetary Economics, Elsevier, vol. 17(2), pages 271-291, March.
  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.
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