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Optimal Monetary Policy Regime Switches

Author

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  • Choi, Jason

    () (University of Wisconsin-Madison)

  • Foerster, Andrew

    () (Federal Reserve Bank of San Francisco)

Abstract

An economy that switches between high and low growth regimes creates incentives for the monetary authority to change its rule. As lower growth tends to produce lower real interest rates, the monetary authority has an incentive to increase the inflation target and increase the degree of inertia in setting rates in an attempt to keep the nominal rate positive. An optimizing monetary authority therefore responds to permanently lower growth by slightly increasing both the inflation target and inertia; focusing solely on the inflation target ignores a key margin of adjustment. With repeated growth rate regime switches, an optimal monetary rule that switches at the same time internalizes both the direct effects of growth regime change and the indirect expectation effects generated by switching in policy. The switching rule improves economic outcomes relative to a constant rule and one that does not consider the impact of regime changes; this result is robust to the case when the monetary authority misidentifies the growth regime with relatively high frequency.

Suggested Citation

  • Choi, Jason & Foerster, Andrew, 2019. "Optimal Monetary Policy Regime Switches," Working Paper Series 2019-3, Federal Reserve Bank of San Francisco.
  • Handle: RePEc:fip:fedfwp:2019-03
    DOI: 10.24148/wp2019-03
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    File URL: https://www.frbsf.org/economic-research/publications/working-papers/2019/03/
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    References listed on IDEAS

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    Cited by:

    1. Smith, A. Lee, 2016. "When does the cost channel pose a challenge to inflation targeting central banks?," European Economic Review, Elsevier, vol. 89(C), pages 471-494.
    2. Andrew Foerster & Troy Davig, 2017. "Communicating Monetary Policy Rules," 2017 Meeting Papers 1133, Society for Economic Dynamics.
    3. Foerster, Andrew T. & Choi, Jason, 2016. "Optimal monetary policy regime switches," Research Working Paper RWP 16-7, Federal Reserve Bank of Kansas City.
    4. repec:eee:dyncon:v:81:y:2017:i:c:p:115-139 is not listed on IDEAS
    5. repec:eee:ecolet:v:172:y:2018:i:c:p:138-142 is not listed on IDEAS
    6. Ascari, Guido & Florio, Anna & Gobbi, Alessandro, 2018. "High trend inflation and passive monetary detours," Economics Letters, Elsevier, vol. 172(C), pages 138-142.
    7. Sebastián Cadavid Sánchez, 2018. "Monetary policy and structural changes in Colombia, 1990-2016: A Markov Switching approach," Documentos CEDE 016970, Universidad de los Andes - CEDE.
    8. Ernst, Ekkehard & Semmler, Willi & Haider, Alexander, 2017. "Debt-deflation, financial market stress and regime change – Evidence from Europe using MRVAR," Journal of Economic Dynamics and Control, Elsevier, vol. 81(C), pages 115-139.

    More about this item

    JEL classification:

    • C63 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Computational Techniques
    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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