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Money supply and the implementation of interest rate targets

  • Schabert, Andreas

In this paper, we analyze the relation between interest rate targets and money supply in a (bubble-free) rational expectations equilibrium of a standard cash-in-advance model. We examine contingent monetary injections aimed to implement interest rate sequences that satisfy interest rate target rules. An interest rate target with a positive inflation feedback in general corresponds to money growth rates rising with inflation. When prices are not completely flexible, this implies that a non-destabilizing money supply cannot implement a forward-looking and active interest rate rule. This principle also applies for an alternative model version with an interest elastic money demand. The implementation of a Taylor-rule then requires a money supply that leads to explosive or oscillatory equilibrium sequences. In contrast, an inertial interest rate target can be implemented by a non-destabilizing money supply, even if the inflation feedback exceeds one, which is often found in interest rate rule regressions. JEL Classification: E52, E41, E32

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Paper provided by European Central Bank in its series Working Paper Series with number 0483.

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Date of creation: May 2005
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Handle: RePEc:ecb:ecbwps:20050483
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