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On measuring the nonlinear effect of interest rates on inflation and output

Listed author(s):
  • Hyeong Ho Moon

    (Department of Economics, University of California at San Diego, USA)

  • Tae-Hwan Kim

    (School of Economics, Yonsei University, South Korea)

  • Seongho Nah

    (Bank of Korea, South Korea)

While economists are interested in the reaction of the interest rate to changes in the inflation rate, central bankers are usually more interested in the reverse causal relationship, i.e., the response of inflation (and output) to a change in the official interest rate as administrated by the central bank. Whether the reverse causal relationship is linear or nonlinear is an empirical issue. We investigated the reverse causal relationship by employing the LSTVAR model proposed by Weise (1999). We found strong evidence in favor of nonlinearity. As a consequence of the nonlinearity, we discovered various types of asymmetric effects of the interest rate on inflation and output. An asymmetric effect of monetary shocks of different sizes was uncovered, which implies that when the unexpected change in the official rate is doubled (i.e. from 0.25% to 0.5%), its effect on inflation and output is likely to be more than doubled. However, this finding is upheld only when the economy is in recession. The opposite result, in which the effect is smaller, is supported when the economy is expanding. Regarding the other asymmetric effect of monetary shocks with different signs, we found that central banks can expect that increasing the official rate by some certain amount (e.g. 0.25%) is likely to have much larger effect on inflation and output than decreasing the rate by the same amount (e.g. -0.25%) regardless of the state of the economy.

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Paper provided by Yonsei University, Yonsei Economics Research Institute in its series Working papers with number 2013rwp-53.

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Length: 22 pages
Date of creation: 13 Feb 2012
Handle: RePEc:yon:wpaper:2013rwp-53
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  1. Terasvirta, T & Anderson, H M, 1992. "Characterizing Nonlinearities in Business Cycles Using Smooth Transition Autoregressive Models," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 7(S), pages 119-136, Suppl. De.
  2. Thanaset Chevapatrakul & Tae-Hwan Kim & Paul Mizen, 2009. "The Taylor Principle and Monetary Policy Approaching a Zero Bound on Nominal Rates: Quantile Regression Results for the United States and Japan," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 41(8), pages 1705-1723, December.
  3. John B. Taylor, 1999. "Introduction to "Monetary Policy Rules"," NBER Chapters,in: Monetary Policy Rules, pages 1-14 National Bureau of Economic Research, Inc.
  4. John B. Taylor, 1999. "A Historical Analysis of Monetary Policy Rules," NBER Chapters,in: Monetary Policy Rules, pages 319-348 National Bureau of Economic Research, Inc.
  5. Clarida, Richard & Gali, Jordi & Gertler, Mark, 1998. "Monetary policy rules in practice Some international evidence," European Economic Review, Elsevier, vol. 42(6), pages 1033-1067, June.
  6. Koop, Gary & Pesaran, M. Hashem & Potter, Simon M., 1996. "Impulse response analysis in nonlinear multivariate models," Journal of Econometrics, Elsevier, vol. 74(1), pages 119-147, September.
  7. Weise, Charles L, 1999. "The Asymmetric Effects of Monetary Policy: A Nonlinear Vector Autoregression Approach," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 31(1), pages 85-108, February.
  8. John B. Taylor, 1999. "Monetary Policy Rules," NBER Books, National Bureau of Economic Research, Inc, number tayl99-1, June.
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