Monetary Policy, Interest Rate Rules, and Inflation Targeting: Some Basic Equivalences

Policymakers increasingly view short-term nominal interest rates as the main instrument of monetary policy, often in conjunction with some inflation target. Interest rates on short-term indexed government debt (i.e., a real interest rate) have also been used as policy instruments. To understand the pros and cons of different policy rules and instruments, this paper derives some basic equivalences among different policy rules. It is shown that , under certain conditions, the following three rules are exactly equivalent: (i) a "k-percent" money growth rule; (ii) a nominal interest rate rule combined with an inflation target, and (iii) a real interest rate rule combined with an inflation target. These policy rules, however, become increasingly complex: the first rule requires no feedback mechanism; the second rule requires responding to the inflation gap; while the third rule involves responding to both the inflation gap and the output gap. It is also shown that money growth rules and nominal interest rate rules which respond to the output gap may deliver better outcomes.(This abstract was borrowed from another version of this item.)