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Optimal Monetary Policy Regime Switches

Author

Listed:
  • Jason Choi

    (University of Wisconsin-Madison)

  • Andrew Foerster

    (Federal Reserve Bank of San Francisco)

Abstract

An economy that switches between high and low growth regimes creates incentives for the monetary authority to change the parameters in its simple rule. As lower growth tends to produce lower real interest rates, the monetary authority has an incentive to increase the inflation target and increase the degree of inertia in setting rates in an attempt to keep the nominal rate away from the zero lower bound. An optimal simple rule therefore responds to permanently lower growth by slightly increasing both the inflation target and inertia; focusing solely on the inflation target ignores a key margin of adjustment. With repeated growth rate regime switches, an optimal simple rule that switches at the same time internalizes both the direct effects of growth regime change and the indirect expectation effects generated by switching in policy. The switching rule improves economic outcomes relative to a constant rule. A constant rule may be preferred if the monetary authority attempts a switching rule but implements the wrong rule with high enough frequency. (Copyright: Elsevier)

Suggested Citation

  • Jason Choi & Andrew Foerster, 2021. "Optimal Monetary Policy Regime Switches," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 42, pages 333-346, October.
  • Handle: RePEc:red:issued:19-148
    DOI: 10.1016/j.red.2020.11.007
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    Cited by:

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    2. Guido Ascari & Anna Florio & Alessandro Gobbi, 2020. "Controlling Inflation With Timid Monetary–Fiscal Regime Changes," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 61(2), pages 1001-1024, May.
    3. Jason Choi & Andrew Foerster, 2021. "Optimal Monetary Policy Regime Switches," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 42, pages 333-346, October.
    4. Ernst, Ekkehard & Semmler, Willi & Haider, Alexander, 2017. "Debt-deflation, financial market stress and regime change – Evidence from Europe using MRVAR," Journal of Economic Dynamics and Control, Elsevier, vol. 81(C), pages 115-139.
    5. Stéphane Lhuissier & Fabien Tripier, 2021. "Regime‐dependent effects of uncertainty shocks: A structural interpretation," Quantitative Economics, Econometric Society, vol. 12(4), pages 1139-1170, November.
    6. Neusser, Klaus, 2019. "Time–varying rational expectations models," Journal of Economic Dynamics and Control, Elsevier, vol. 107(C), pages 1-1.
    7. Ascari, Guido & Florio, Anna & Gobbi, Alessandro, 2018. "High trend inflation and passive monetary detours," Economics Letters, Elsevier, vol. 172(C), pages 138-142.
    8. Sebastián Cadavid Sánchez, 2018. "Monetary policy and structural changes in Colombia, 1990-2016: A Markov Switching approach," Documentos CEDE 16970, Universidad de los Andes, Facultad de Economía, CEDE.
    9. Faulwasser Timm & Gross Marco & Loungani Prakash & Semmler Willi, 2020. "Unconventional monetary policy in a nonlinear quadratic model," Studies in Nonlinear Dynamics & Econometrics, De Gruyter, vol. 24(5), pages 1-19, December.
    10. Smith, A. Lee, 2016. "When does the cost channel pose a challenge to inflation targeting central banks?," European Economic Review, Elsevier, vol. 89(C), pages 471-494.

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    More about this item

    Keywords

    Growth rate; Optimal policy; Regime switching; Taylor rule; Inflation target; Zero lower bound;
    All these keywords.

    JEL classification:

    • C63 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Computational Techniques
    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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