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Interest Rate Stepping, Interest Rate Smoothing and Uncertainty: Some Views from the Literature

  • W.H. Verhagen
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    This report analyses some of the reasons mentioned in the literature as to why central banks change interest rates at discrete intervals in the face of a continuously changing environment (interest rate stepping) and why they seem to prefer to implement changes in a series of small steps (interest rate smoothing). Despite the fact that both seem difficult to explain within the certainty equivalent optimal control framework frequently used to study monetary policy, it appears that modifying some of the assumptions of these models go a long way in explaining these phenomena. In particular, replacing the assumption that all uncertainty takes the form of additive shocks with known probability distributions with perhaps more realistic ways to model uncertainty will often yield stepping and smoothing as features of an optimal interest rate rule.

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    Paper provided by Netherlands Central Bank, Research Department in its series WO Research Memoranda (discontinued) with number 683.

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    Date of creation: 2002
    Date of revision:
    Handle: RePEc:dnb:wormem:683
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    1. Richard Clarida & Jordi Galí & Mark Gertler, 1997. "The science of monetary policy: A new Keynesian perspective," Economics Working Papers 356, Department of Economics and Business, Universitat Pompeu Fabra, revised Apr 1999.
    2. Peter von zur Muehlen, 2001. "Activist vs. non-activist monetary policy: optimal rules under extreme uncertainty," Finance and Economics Discussion Series 2001-02, Board of Governors of the Federal Reserve System (U.S.).
    3. Cukierman, Alex & Meltzer, Allan H, 1986. "A Theory of Ambiguity, Credibility, and Inflation under Discretion and Asymmetric Information," Econometrica, Econometric Society, vol. 54(5), pages 1099-1128, September.
    4. Woodford, Michael, 1999. "Optimal Monetary Policy Inertia," Manchester School, University of Manchester, vol. 67(0), pages 1-35, Supplemen.
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    6. Lars E. O. Svensson, 1996. "Inflation Forecast Targeting: Implementing and Monitoring Inflation Targets," NBER Working Papers 5797, National Bureau of Economic Research, Inc.
    7. Alex Cukierman, 2002. "Are contemporary central banks transparent about economic models and objectives and what difference does it make?," Review, Federal Reserve Bank of St. Louis, issue Jul, pages 15-36.
    8. 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.
    9. Backus, David & Driffill, John, 1985. "Inflation and Reputation," American Economic Review, American Economic Association, vol. 75(3), pages 530-38, June.
    10. Charles Goodhart, 1998. "Central Bankers and Uncertainty," FMG Special Papers sp106, Financial Markets Group.
    11. Alan S. Blinder, 1999. "Central Banking in Theory and Practice," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262522608, December.
    12. Robert J. Barro, 1986. "Reputation in a Model of Monetary Policy with Incomplete Information," NBER Working Papers 1794, National Bureau of Economic Research, Inc.
    13. Alex Cukierman, 1992. "Central Bank Strategy, Credibility, and Independence: Theory and Evidence," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262031981, December.
    14. Marvin Goodfriend, 1990. "Interest rates and the conduct of monetary policy," Working Paper 90-06, Federal Reserve Bank of Richmond.
    15. Bennett T. McCallum, 1995. "Two Fallacies Concerning Central Bank Independence," NBER Working Papers 5075, National Bureau of Economic Research, Inc.
    16. Milton Friedman, 1971. "A Theoretical Framework for Monetary Analysis," NBER Books, National Bureau of Economic Research, Inc, number frie71-1, September.
    17. Sargent, Thomas J & Wallace, Neil, 1975. ""Rational" Expectations, the Optimal Monetary Instrument, and the Optimal Money Supply Rule," Journal of Political Economy, University of Chicago Press, vol. 83(2), pages 241-54, April.
    18. Lucas, Robert Jr, 1976. "Econometric policy evaluation: A critique," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 1(1), pages 19-46, January.
    19. Kenneth Rogoff, 1985. "The Optimal Degree of Commitment to an Intermediate Monetary Target," The Quarterly Journal of Economics, Oxford University Press, vol. 100(4), pages 1169-1189.
    20. Glenn D. Rudebusch, 2001. "Term structure evidence on interest rate smoothing and monetary policy inertia," Working Paper Series 2001-02, Federal Reserve Bank of San Francisco.
    21. Philip Lowe & Luci Ellis, 1997. "The Smoothing of Official Interest Rates," RBA Annual Conference Volume, in: Philip Lowe (ed.), Monetary Policy and Inflation Targeting Reserve Bank of Australia.
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