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Why Central Banks Smooth Interest Rates? A Political Economy Explanation

  • Carlos Montoro

    ()

    (Central Bank of Peru, LSE)

We extend the New Keynesian Monetary Policy literature relaxing the assumption that the decisions are taken by a single policymaker, considering instead that monetary policy decisions are taken collectively in a committee. We introduce a Monetary Policy Committee (MPC), whose members have different preferences between output and inflation variability and have to vote on the level of the interest rate. This paper helps to explain interest rate smoothing from a political economy point of view, in which MPC members face a bargaining problem on the level of the interest rate. In this framework, the interest rate is a non-linear reaction function on the lagged interest rate and the expected inflation. This result comes from a political equilibrium in which there is a strategic behaviour of the agenda setter with respect to the rest MPC’s members. Our approach can also reproduce both features documented by the empirical evidence on interest rate smoothing: a) the modest response of the interest rate to inflation. and output gap; and. b) the dependence on lagged interest rate. Features that are difficult to reproduce alltogether in standard New Keynesian models. It also provides a theoretical framework on how disagreement among policymakers can slow down the adjustment on interest rates and on “menu costs” in interest rate decisions. Furthermore, a numerical excercise shows that this inertial behaviour of the interest rate is internalised by the economic agents through an increase in expected inflation.

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Paper provided by Banco Central de Reserva del Perú in its series Working Papers with number 2007-003.

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Date of creation: Mar 2007
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Handle: RePEc:rbp:wpaper:2007-003
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  1. Alessandro Riboni, 2010. "Committees As Substitutes For Commitment," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 51(1), pages 213-236, 02.
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  7. Gerlach-Kristen, Petra, 2008. "Taking two steps at a time: On the optimal pattern of policy interest rates," Journal of Economic Dynamics and Control, Elsevier, vol. 32(2), pages 550-570, February.
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  9. Gerlach-Kristen, Petra, 2005. "Too little, too late: Interest rate setting and the costs of consensus," Economics Letters, Elsevier, vol. 88(3), pages 376-381, September.
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  12. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 195-214, December.
  13. Alessandro Riboni & Francisco J. Ruge-Murcia, 2008. "The Dynamic (In)Efficiency of Monetary Policy by Committee," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 40(5), pages 1001-1032, 08.
  14. Brian Sack, 1998. "Does the Fed act gradually? a VAR analysis," Finance and Economics Discussion Series 1998-17, Board of Governors of the Federal Reserve System (U.S.).
  15. Charles Goodhart, 2004. "The Monetary Policy Committee's reaction function: an exercise in estimation," LSE Research Online Documents on Economics 24708, London School of Economics and Political Science, LSE Library.
  16. Hahn, Volker & Gersbach, Hans, 2001. "Should the Individual Voting Records of Central Bankers be Published?," Discussion Paper Series 1: Economic Studies 2001,02, Deutsche Bundesbank, Research Centre.
  17. Woodford, Michael, 2000. "Optimal Monetary Policy Inertia," Seminar Papers 666, Stockholm University, Institute for International Economic Studies.
  18. Gerlach-Kristen, Petra, 2006. "Monetary policy committees and interest rate setting," European Economic Review, Elsevier, vol. 50(2), pages 487-507, February.
  19. von Hagen, Jurgen & Suppel, Ralph, 1994. "Central bank constitutions for federal monetary unions," European Economic Review, Elsevier, vol. 38(3-4), pages 774-782, April.
  20. Petra Gerlach-Kristen, 2009. "Outsiders at the Bank of England's MPC," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 41(6), pages 1099-1115, 09.
  21. Richard Clarida & Jordi Gali & Mark Gertler, 1997. "Monetary Policy Rules in Practice: Some International Evidence," NBER Working Papers 6254, National Bureau of Economic Research, Inc.
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  23. Athanasios Orphanides, 2001. "Monetary Policy Rules Based on Real-Time Data," American Economic Review, American Economic Association, vol. 91(4), pages 964-985, September.
  24. Alessandro Riboni, 2004. "Time Consistency in Dynamic Bargaining: The Role of Committees as Substitutes for Commitment," 2004 Meeting Papers 684, Society for Economic Dynamics.
  25. Süppel, Ralph & von Hagen, Jürgen, 1994. "Central Bank Constitutions for Monetary Unions," CEPR Discussion Papers 919, C.E.P.R. Discussion Papers.
  26. Gerlach-Kristen Petra, 2004. "Interest-Rate Smoothing: Monetary Policy Inertia or Unobserved Variables?," The B.E. Journal of Macroeconomics, De Gruyter, vol. 4(1), pages 1-19, March.
  27. Philip Lowe & Luci Ellis, 1997. "The Smoothing of Official Interest Rates," RBA Annual Conference Volume, in: Philip Lowe (ed.), Monetary Policy and Inflation Targeting Reserve Bank of Australia.
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