The Value of Interest-rate Smoothing in a Forward-looking Small Open Economy

In this paper, the impact of interest-rate smoothing under Taylor-type rules in the context of a two-sector small open economy is considered. The normative question of whether interest-rate smoothing as a policy response is beneficial for household welfare over the business cycle of the small open economy is addressed. The model also allows for the existence of habit formation where consumers’ aversion to risk varies inversely with their state of consumption. It is shown that under a Taylor-type rule without explicit lagged-interest-rate response, interest rates can still become more sluggish when consumer habit is long drawn out. Furthermore, the existence of habit improves the persistence of key macroeconomic variables, especially the nominal and real exchange rates. It is found that “super-inertial” policy can be welfare improving only when the central bank uses a simple rule that strongly reacts to contemporaneous inflation and output, and is especially tough on the former. This result, subject to numerically possible and empirically plausible parameterization, is reinforced in the increasing direction of habit persistence and pricestickiness. Furthermore, when adding an inflation forecast term in the rule, business cycle and welfare outcomes worsen. However, welfare improves when interest-rates become more super-inertial, given an inflation-forecast term in the rule.