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Reaction Function Estimation when Central Banks Face Adjustment Costs

  • Roszbach, Kasper

    ()

    (Department of Economics)

The main instrument of monetary policy in industrialized countries is currently a short-term interest rate. It typically remains unchanged during long spans of time. This paper tries to answer three questions. Why do Central Banks change targeted interest rates so seldom? How should we estimate Central banks' reaction functions? And what are the driving forces behind rate changes? This paper takes the point of view that Central Banks face a fixed cost when adjusting the targeted interest rate and therefore smoothe the targeted interest rate by using a discrete policy rule. In the estimation of the reaction function this discrete nature is taken into account by applying a grouped data model to a Swedish data set. It is found that the reaction function is best represented in terms of changes in growth rates of macro variables and changes in levels of financial variables. Probabilities of the target rate being raised, lowered or kept constant are computed and compared with actual interest rate behavior. The model has a prediction rate of 88% versus 78% for the best naive estimator.

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Paper provided by Stockholm School of Economics in its series SSE/EFI Working Paper Series in Economics and Finance with number 155.

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Length: 28 pages
Date of creation: Jan 1997
Date of revision:
Handle: RePEc:hhs:hastef:0155
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  1. Edin, Per-Anders & Vredin, Anders, 1993. "Devaluation Risk in Target Zones: Evidence from the Nordic Countries," Economic Journal, Royal Economic Society, vol. 103(416), pages 161-75, January.
  2. Barro, Robert J & Gordon, David B, 1983. "A Positive Theory of Monetary Policy in a Natural Rate Model," Journal of Political Economy, University of Chicago Press, vol. 91(4), pages 589-610, August.
  3. Alex Cukierman, 1989. "Why does the Fed smooth interest rates?," Proceedings, Federal Reserve Bank of St. Louis, pages 111-157.
  4. Barro, Robert J., 1989. "Interest-rate targeting," Journal of Monetary Economics, Elsevier, vol. 23(1), pages 3-30, January.
  5. Stephen G. Cecchetti, 1996. "Practical issues in monetary policy targeting," Economic Review, Federal Reserve Bank of Cleveland, issue Q I, pages 2-15.
  6. Alexius, Annika, 1999. "Inflation rules with consistent escape clauses," European Economic Review, Elsevier, vol. 43(3), pages 509-523, March.
  7. Eichengreen, Barry & Watson, Mark W & Grossman, Richard S, 1985. "Bank Rate Policy under the Interwar Gold Standard: A Dynamic Probit Model," Economic Journal, Royal Economic Society, vol. 95(379), pages 725-45, September.
  8. Bernanke, Ben S & Blinder, Alan S, 1992. "The Federal Funds Rate and the Channels of Monetary Transmission," American Economic Review, American Economic Association, vol. 82(4), pages 901-21, September.
  9. Lawrence J. Christiano & Martin Eichenbaum, 1991. "Identification and the Liquidity Effect of a Monetary Policy Shock," NBER Working Papers 3920, National Bureau of Economic Research, Inc.
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