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A Case for Interest Rate Inertia in Monetary Policy

  • Bask, Mikael


    (Department of Economics)

We argue that it is not necessary for the central bank to react to the exchange rate to have a desirable outcome in the economy. Indeed, when the Taylor rule includes contemporaneous data on the variables in the rule, the central bank can disregard from the exchange rate as long as there is enough with interest rate inertia in monetary policy. The reason is that interest rate inertia and a reaction to the current nominal exchange rate change are perfect substitutes in monetary policy. Hence, we give a rationale for the central bank to focus on the interest rate change rather than the interest rate level to have a desirable outcome in the economy, which we define as a determinate rational expectation equilibrium that is stable under least squares learning.

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Paper provided by Uppsala University, Department of Economics in its series Working Paper Series with number 2011:16.

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Length: 33 pages
Date of creation: 19 Oct 2011
Date of revision:
Handle: RePEc:hhs:uunewp:2011_016
Contact details of provider: Postal: Department of Economics, Uppsala University, P. O. Box 513, SE-751 20 Uppsala, Sweden
Phone: + 46 18 471 25 00
Fax: + 46 18 471 14 78
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  9. Leitemo, Kai & Söderström, Ulf, 2001. "Simple Monetary Policy Rules and Exchange Rate Uncertainty," Working Paper Series 122, Sveriges Riksbank (Central Bank of Sweden).
  10. Fabrizio Zampolli, 2006. "Optimal monetary policy in a regime-switching economy: the response to abrupt shifts in exchange rate dynamics," Bank of England working papers 297, Bank of England.
  11. Bask, Mikael, 2007. "Optimal monetary policy under heterogeneity in currency trade," Research Discussion Papers 21/2007, Bank of Finland.
  12. Woodford, Michael, 2000. "Optimal Monetary Policy Inertia," Seminar Papers 666, Stockholm University, Institute for International Economic Studies.
  13. Marcet, Albert & Sargent, Thomas J., 1989. "Convergence of least squares learning mechanisms in self-referential linear stochastic models," Journal of Economic Theory, Elsevier, vol. 48(2), pages 337-368, August.
  14. McCallum, Bennett T., 2007. "E-stability vis-a-vis determinacy results for a broad class of linear rational expectations models," Journal of Economic Dynamics and Control, Elsevier, vol. 31(4), pages 1376-1391, April.
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  17. Bask, Mikael, 2009. "Instrument rules in monetary policy under heterogeneity in currency trade," Journal of Economics and Business, Elsevier, vol. 61(2), pages 97-111.
  18. Fernando Alexandre & Pedro Bação & John Driffill, 2011. "Bubbles In Exchange Rates And Monetary Policy," Scottish Journal of Political Economy, Scottish Economic Society, vol. 58(1), pages 29-50, February.
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  20. Vicente Tuesta & Gonzalo Llosa, 2006. "Determinacy and Learnability of Monetary Policy Rules in Small Open Economies," IDB Publications (Working Papers) 6838, Inter-American Development Bank.
  21. James B. Bullard & Kaushik Mitra, 2003. "Determinacy, learnability, and monetary policy inertia," Working Papers 2000-030, Federal Reserve Bank of St. Louis.
  22. Blanchard, Olivier Jean & Kahn, Charles M, 1980. "The Solution of Linear Difference Models under Rational Expectations," Econometrica, Econometric Society, vol. 48(5), pages 1305-11, July.
  23. Cavoli, Tony, 2008. "The exchange rate and optimal monetary policy rules in open and developing economies: Some simple analytics," Economic Modelling, Elsevier, vol. 25(5), pages 1011-1021, September.
  24. 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.
  25. Lubik, Thomas A. & Schorfheide, Frank, 2007. "Do central banks respond to exchange rate movements? A structural investigation," Journal of Monetary Economics, Elsevier, vol. 54(4), pages 1069-1087, May.
  26. Mikael Bask, 2012. "Asset Price Misalignments And Monetary Policy," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 17(3), pages 221-241, 07.
  27. Divino, Jose Angelo, 2009. "Optimal monetary policy for a small open economy," Economic Modelling, Elsevier, vol. 26(2), pages 352-358, March.
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