Supply Side Shocks, Near Rational Expectations, Cost Channel, and Monetary Policy

Abstract

This paper examines the effectiveness of interest rate policy to stabilize the economy in general and to control inflation in particular. The paper utilizes a dynamic model which has firmer microeconomic foundations. The model is used to establish links between inflation and other variables such as wages, interest rate, and expected output. The paper highlights the importance of supply-side effects of interest rate and the role of near rational expectations in determining both nominal and real variables. The dynamic model is used to calculate the impulse response function and welfare loss to the society. The impulse response emanating from supply-side shock was used to examine various interest rate polices. Interest rate policies were distinguished based on their ability to control inflation and minimization of the overall welfare loss. This paper supports the policy of inflation targeting. It is further argued that it is unwise to increase interest rate in line with inflation as suggested by the Taylor rule.