Thinking afresh about central bank’s interest rate policy

Abstract

Purpose– The purpose of the paper is to improve policy, and also to simplify theory and policy.Design/methodology/approach– Theory is used in a simple and yet powerful way. Stylized facts are used. This paper reconsiders the prevailing macroeconomic policy regime, and proposes an alternative policy regime.Findings– The low interest rate policy of the central bank in a recession is tantamount to imposition of tax on lenders’ interest income and a subsidy for borrowers implying an implicit tax-subsidy scheme. This scheme may be replaced by a different and explicit tax-subsidy scheme. This may also be supplemented by lower consumption taxes in a recession. From the viewpoint of stabilization of aggregate demand, the prevailing policy regime and the proposed policy regime can be equivalent. However, from the viewpoint of general macroeconomic and asset price stability, the proposed policy regime is superior, though it has (additional) cost of administration.Social implications– Macroeconomic and financial instability has large social cost. This paper can be useful in this context, as it has suggestions for improved macroeconomic policy. It also has policy implications for developing countries and highly indebted countries.Originality/value– This paper’s innovation goes well beyond refinements to prevailing theories and policies. Also, it paves the way for further research.