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Interest Rate Smoothing and Inflation-Output Variabilityin a Small Open Economy

  • T.C.Y. Kam
  • G.C. Lim

This paper is concerned with the relationship between the interest rate smoothing behavior of a central bank and the variability of inflation and output. The issue is analyzed through the lens of a small open economy dynamic stochastic general equilibrium model with nontraded goods price rigidities and habit persistence. The benchmark model is calibrated to match certain key business cycle features of a small open economy like Australia. Relative to the benchmark model, experiments on a Taylor rule with interest rate smoothing are conducted. Due to the existence of a short run expectational Phillips curve in the model, monetary policy will imply certain trade-offs between inflation and output variance, under sensible parameter values of the model. More importantly, in a world where there exists such a trade-off, greater interest rate smoothing in the Taylor rule can potentially yield lower sacrifices in terms of output variability in return for lower inflation, thus increasing policy effectiveness.

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Paper provided by The University of Melbourne in its series Department of Economics - Working Papers Series with number 817.

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Length: 26 pages
Date of creation: 2001
Date of revision:
Handle: RePEc:mlb:wpaper:817
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