Persistence and the Role of Exchange Rate and Interest Rate Inertia in Monetary Policy

In a general equilibrium model, this paper investigates the importance of the exchange rate and the interpretation of the observed inertia in the policy interest rate. We derive an optimizing macroeconomic model that features habit formation in the consumer's utility function and uses a hybrid New Keynesian Phillips curve with inflation inertia. As a consequence, aggregate demand and supply shocks will have a persistent effect on output and inflation. In this framework, we assess the performance of simple, and perhaps non-optimal, interest rate rules under different degrees of habit formation and inflation persistence. We conclude that a policy rule that responds to expected inflation, as well as to output and the exchange rate, is able to reduce output and inflation volatility in the face of aggregate demand and foreign inflation shocks. This result must be interpreted with caution, because, as is found in other studies, i) the reduction in volatility is marginal and ii) the Taylor-type policy rule assessed here may be a restrictive one and, as mentioned before, non-optimal. On the other hand, the gains from adopting an inertial interest rate rule are directly related to the degree of inflation persistence in the model. In particular, when the degree of inflation persistence is high, an inertial policy rule attenuates the impacts that supply shocks have on inflation and the interest rate.