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Optimal Monetary Policy Inertia

  • Woodford, Michael

    (Princeton University)

This paper considers the desirability of the observed tendency of central banks to adjust interest rates only gradually in response to changes in economic conditions. It shows, in the context of a simple model of optimizing private-sector behavior, that such inertial behavior on the part of the central bank may indeed be optimal, in the sense of minimizing a loss function that penalizes inflation variations, deviations of output from potential, and interest-rate variability. Sluggish adjustment characterizes an optimal policy commitment, even though no such inertia would be present in the case of a reputationless (Markovian) equilibrium under discretion. Optimal interest-rate feedback rules are also characterized, and shown to involve substantial positive coefficients on lagged interest rates. This provides a theoretical explanation for the numerical results obtained by Rotemberg and Woodford (1998) in their quantitative model of the U.S. economy.

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Paper provided by Stockholm University, Institute for International Economic Studies in its series Seminar Papers with number 666.

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Length: 112 pages
Date of creation: 03 Nov 2000
Date of revision:
Handle: RePEc:hhs:iiessp:0666
Note: A later version of the paper is also available as NBER working paper no. 7261, July 1999, and at the author's web page at www.princeton.edu/~woodford.
Contact details of provider: Postal: Institute for International Economic Studies, Stockholm University, S-106 91 Stockholm, Sweden
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