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Gains from interest-rate smoothing in a small open economy with zero-bound aversion

We extend the Monacelli [Monacelli, T. (2005). Monetary policy in a low pass-through environment. Journal of Money, Credit and Banking, 37(6), 1047-1066] model to allow for a central bank that penalizes nominal interest rate paths that are too close to the zero lower bound. We analytically derive the optimal interest-rate policy rule in each equilibrium under four policy regimes: (i) benchmark commitment to an ex-ante optimal monetary-policy plan; (ii) benchmark discretionary policy; (iii) optimal delegation to a discretionary policy maker with similar preferences to society; and (iv) optimal delegation to a discretionary policy maker with an additional taste for interest-rate smoothing. Under the commitment benchmark, the optimal interest-rate rule is proved to be intrinsically inertial, whereas this property is non-existent under discretionary policy. In the absence of commitment, there are gains to delegating policy to an interest-rate smoothing central banker. We show that while the endogenous law of one price gap in the model exacerbates the optimal policy trade-off that arises under discretionary policy, the latter feature of interest-rate smoothing acts to weaken it, by mimicking intrinsic inertia under the commitment policy.

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Article provided by Elsevier in its journal The North American Journal of Economics and Finance.

Volume (Year): 20 (2009)
Issue (Month): 1 (March)
Pages: 24-45

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Handle: RePEc:eee:ecofin:v:20:y:2009:i:1:p:24-45
Contact details of provider: Web page: http://www.elsevier.com/locate/inca/620163

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  1. Jensen, Henrik, 1999. "Targeting Nominal Income Growth or Inflation?," CEPR Discussion Papers 2341, C.E.P.R. Discussion Papers.
  2. Klaus Adam & Roberto M. Billi, 2005. "Discretionary monetary policy and the zero lower bound on nominal interest rates," Research Working Paper RWP 05-08, Federal Reserve Bank of Kansas City.
  3. Rogoff, Kenneth, 1985. "The Optimal Degree of Commitment to an Intermediate Monetary Target," The Quarterly Journal of Economics, MIT Press, vol. 100(4), pages 1169-89, November.
  4. Galí, Jordi & Monacelli, Tommaso, 2002. "Monetary Policy and Exchange Rate Volatility in a Small Open Economy," CEPR Discussion Papers 3346, C.E.P.R. Discussion Papers.
  5. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
  6. Woodford, Michael, 1999. "Optimal Monetary Policy Inertia," Manchester School, University of Manchester, vol. 67(0), pages 1-35, Supplemen.
  7. Marco A. Espinosa-Vega & Alessandro Rebucci, 2004. "Retail Bank Interest Rate Pass-through: Is Chile Atypical?," Central Banking, Analysis, and Economic Policies Book Series, in: Luis Antonio Ahumada & J. Rodrigo Fuentes & Norman Loayza (Series Editor) & Klaus Schmidt-Hebbel (Se (ed.), Banking Market Structure and Monetary Policy, edition 1, volume 7, chapter 5, pages 147-182 Central Bank of Chile.
  8. Klaus Adam & Roberto M. Billi, 2005. "Optimal monetary policy under commitment with a zero bound on nominal interest rates," Research Working Paper RWP 05-07, Federal Reserve Bank of Kansas City.
  9. Jeffery D. Amato & Thomas Laubach, 2002. "Rule-of-thumb behaviour and monetary policy," Finance and Economics Discussion Series 2002-5, Board of Governors of the Federal Reserve System (U.S.).
  10. Clarida, R. & Gali, J. & Gertler, M., 1999. "The Science of Monetary Policy: A New Keynesian Perspective," Working Papers 99-13, C.V. Starr Center for Applied Economics, New York University.
  11. Richard Clarida & Jordi Gali & Mark Gertler, 2001. "Optimal Monetary Policy in Open versus Closed Economies: An Integrated Approach," American Economic Review, American Economic Association, vol. 91(2), pages 248-252, May.
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