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A Theory of Interest Rate Stepping: Inflation Targeting in a Dynamic Menu Cost Model

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  • Eijffinger, Sylvester C W
  • Schaling, Eric
  • Verhagen, Willem

Abstract

A stylised fact of monetary policy making is that central banks do not immediately respond to new information but rather seem to prefer to wait until sufficient 'evidence' to warrant a change has accumulated. However, theoretical models of inflation targeting imply that an optimising central bank should continuously respond to shocks. This paper attempts to explain this stylised fact by introducing a small menu cost which is incurred every time the central bank changes the interest rate. It is shown that this produces a relatively large range of inaction because this cost will induce the central bank to take the option value of the status quo into account. In other words, because action is costly the central bank will have an incentive to wait and see whether or not the economy will move closer to the inflation target of its own accord. Next, the paper analyses the implications for the time series properties of interest rates. In particular, we examine the effect of the interest rate sensitivity of aggregate demand, the slope of the Lucas supply function and the variance of demand shocks on the size of the interest rate step and the expected length of the time period till the next interest rate step. Finally, we analyse the effect of menu costs on inflationary expectations. In this respect we find that the economy will suffer from an inflationary bias if the cost of raising the interest rate exceeds the cost of lowering it.

Suggested Citation

  • Eijffinger, Sylvester C W & Schaling, Eric & Verhagen, Willem, 1999. "A Theory of Interest Rate Stepping: Inflation Targeting in a Dynamic Menu Cost Model," CEPR Discussion Papers 2168, C.E.P.R. Discussion Papers.
  • Handle: RePEc:cpr:ceprdp:2168
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    References listed on IDEAS

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    1. repec:dau:papers:123456789/7716 is not listed on IDEAS
    2. W.H. Verhagen, 2002. "Interest Rate Stepping, Interest Rate Smoothing and Uncertainty: Some Views from the Literature," WO Research Memoranda (discontinued) 683, Netherlands Central Bank, Research Department.
    3. Adam Cagliarini & Guy Debelle, 2002. "The Effect of Uncertainty on Monetary Policy: How Good are the Brakes?," Central Banking, Analysis, and Economic Policies Book Series,in: Norman Loayza & Klaus Schmidt-Hebbel & Norman Loayza (Series Editor) & Klaus Schmidt-Hebbel (Series (ed.), Monetary Policy: Rules and Transmission Mechanisms, edition 1, volume 4, chapter 7, pages 167-196 Central Bank of Chile.
    4. Alessandro Riboni & Francisco J. Ruge-Murcia, 2008. "The Dynamic (In)Efficiency of Monetary Policy by Committee," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 40(5), pages 1001-1032, August.
    5. Gerlach-Kristen, Petra, 2008. "Taking two steps at a time: On the optimal pattern of policy interest rates," Journal of Economic Dynamics and Control, Elsevier, vol. 32(2), pages 550-570, February.
    6. Brooks, Robert & Harris, Mark & Spencer, Christopher, 2007. "An Inflated Ordered Probit Model of Monetary Policy: Evidence from MPC Voting Data," MPRA Paper 8509, University Library of Munich, Germany.
    7. Rudebusch, Glenn D., 2002. "Term structure evidence on interest rate smoothing and monetary policy inertia," Journal of Monetary Economics, Elsevier, vol. 49(6), pages 1161-1187, September.
    8. Giorgio Valente, 2003. "Monetary policy rules and regime shifts," Applied Financial Economics, Taylor & Francis Journals, vol. 13(7), pages 525-535.
    9. VanderHart, Peter G., 2009. "What is the best way to impede a central bank?," The Quarterly Review of Economics and Finance, Elsevier, vol. 49(3), pages 784-797, August.

    More about this item

    Keywords

    Dynamic Menu Costs; Inflation Targeting; Uncertainty;

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies

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