Optimal Interest Rate Research Articles

Money as Indicator for the Natural Rate of Interest

The natural interest rate is of great relevance to central banks, but it is difficult to measure. We show that in a standard microfounded monetary model, the natural interest rate co-moves with a transformation of the money demand that can be computed from actual data. The co-movement is of a considerable magnitude and independent of monetary policy. An optimizing central bank that does not observe the natural interest rate can take advantage of this co-movement by incorporating the transformed money demand, in addition to the observed output gap and inflation, into a simple but optimal interest rate rule. Combining the transformed money demand and the observed output gap provides the best information about the natural interest rate.

Learning about the Term Structure and Optimal Rules for Inflation Targeting

In this paper we incorporate the term structure of interest rates in a standard in∞ation forecast targeting framework. We flnd that under ∞exible in∞ation targeting and uncertainty in the degree of persistence in the economy, allowing for active learning possibilities has efiects on the optimal interest rate rule followed by the central bank. For a wide range of possible initial beliefs about the unknown parameter, the dynamically optimal rule is in general more activist, in the sense of responding aggressively to the state of the economy, than the myopic rule for small to moderate deviations of the state variable from its target. On the other hand, for large deviations, the optimal policy is less activist than the myopic and the certainty equivalence policies.

INTEREST RATE DECISION MODEL BASED ON CVAR BY CONSIDERING DECISION-MAKING BEHAVIOR OF THE BORROWER

Interest rate is one of the important indicators for banks and other financial institutions to balance the risks and gains.In this paper,based on the decision-making behavior of the borrower,a model for interest rate decision based on the conditional value-at-risk(CVaR) is established,and the optimal interest rate is obtained.Numerical analysis shows that the level of risk aversion directly effects interest rate decision;CVaR could help banks to balance profit and risk;borrowers' profit rate and internal capital are the key factors for bank evading risk.

Limited Asset Market Participation: Does it Really Matter for Monetary Policy?

We study the design of monetary policy in an economy characterized by staggered wage and price contracts together with limited asset market participation (LAMP). Contrary to previous results, we find that once nominal wage stickiness, an incontrovertible empirical fact, is considered: The Taylor Principle is restored as a necessary condition for equilibrium determinacy for any empirically plausible degree of LAMP; the implications of LAMP for the design of optimal monetary policy are minor; optimal interest rate rules become active no matter the degree of asset market participation. For these reasons we argue that LAMP is not particularly important for monetary policy.

Current Account Imbalances in the Euro Area: The Role of Monetary Policy

This paper provides an alternative approach in explaining current account imbalances within the euro area. The inability of the ECB to react to disparities in inflation and economic growth between EMU members results in persistent real interest rate differentials, which in turn cause divergent current accounts among EMU member states. Using Taylor rules we assess an optimal interest rate for each EMU member separately. The deviation between realized euro and optimal country-specific c interest rate, employed in a panel estimation, exhibits a significantly strong impact on current account imbalances and proves to be robust to various specifications.

Exchange rate dynamics under alternative optimal interest rate rules

We explore the role of interest rate policy in the exchange rate determination process. Specifically, we derive exchange rate equations from interest rate rules that are theoretically optimal under a few alternative settings. The exchange rate equation depends on its underlying interest rule and its performance could vary across evaluation criteria and sample periods. The exchange rate equation implied by the interest rate rule that allows for interest rate and inflation inertia under commitment offers some encouraging results — exchange rate changes “calibrated” from the equation have a positive and significant correlation with actual data, and offer good direction of change prediction. Our exercise also demonstrates the role of the foreign exchange risk premium in determining exchange rates and the difficulty of explaining exchange rate variability using only policy based fundamentals.

Household's preferences and monetary policy inertia

Interest rates set by central banks puzzlingly move with a certain inertia. We show that household's preferences can be important determinants of the optimal interest rate inertia due to their impact on the efficiency of the monetary policy transmission mechanism.

Optimal monetary and audit policy with imperfect taxation

We study optimal monetary and fiscal policy in the presence of informal activities and tax evasion in a cash-and-credit model where identical households are audited to determine their compliance with the tax code. Taxation of informal labor is imperfect, but the government has tools to deal with informal activities and can choose them optimally to reduce fiscal distortions. We characterize both the optimal monetary (optimal interest rate) and fiscal policy (optimal income tax, evasion penalty and audit probability). When auditing is costless, a nominal interest rate equal to zero is optimal and attained when all agents are audited and both types of labor are taxed at the same rate. In the presence of auditing costs, the optimal audit policy does not follow the Friedman rule, and we report the welfare costs of implementing this monetary policy prescription. We derive conditions under which the Friedman rule can be recovered in an economy with informal activities.

E-Finance, Entry Deterrence, and Optimal Loan Rate of a Potential Entrant: An Option-Based Valuation

This paper examines the relationships among electronic finance (e-finance), entry deterrence, and the potential entrant's optimal loan interest rate in a two-stage model where the sunk costs are the entry barriers. The two key findings are: (i) in the loan rate determination stage, the potential entrant's loan rate is negatively related to its involvement level in e-finance with its own strategic substitutes, to the incumbent's involvement level in e-finance in realization of a more risky state of the world, and to the degree of contestability in realization of a less risky state and (ii) in the technology choice stage, the potential entrant's involvement level in e-finance is positively related to the incumbent's own strategic complements, and to the degree of contestability in realization of a more risky state. The results suggest that a potential entrant's banking investment depends on strong strategic management practices and the realization of risky states of the world.

A Financial Approach to Optimal Interest Rate Rules: Multiple Objectives and Asymmetries

The dominant approach to monetary policy builds on simple linear policy rules, assumed to describe the systematic response of central banks to various shocks. The last financial crisis has shown that in difficult times central banks follow more sophisticated strategies. We argue in this paper that such responses can be defined as optimal responses of the policymaker and not as deviations from a simple linear rule. For so doing, we propose an alternative approach inspired by the financial management literature. The central bank is represented as a portfolio manager that gears the policy instrument in order to achieve multiple policy goals in a stochastic continuous-time setting. Possible asymmetries in the reaction function are considered, translated in the form of calls and puts. The optimization program solution is interpreted in the light of the principles governing the portfolio manager optimal behavior. A novel result is also provided as to the necessity to incorporate the stock price stabilization term in the central bank decision rule.

The role of liquidity constraints in the response of monetary policy to house prices

We analyse the optimal response of monetary policy to house prices in a New Keynesian framework. A positive wealth effect from housing is derived from liquidity constrained consumers. Housing equity withdrawal allows them to convert an increase in housing value into consumption and we show that monetary policy should react to house prices due to their effect on consumption by constrained agents. Moreover, we allow the share of liquidity constrained consumers to vary with house prices. Consequently, the optimal weights on expected inflation, the output gap and house prices in the optimal interest rate rule vary over time too.

The Cost Channel of Monetary Policy Transmission

In this paper, we develop the new Keynesian Phillips curve augmented by the cost channel of monetary transmission and analyze the central bank's best monetary policy if the central bank is obliged to minimize inflation. It can be shown that a small change of the cost channel's coefficient might lead from a major increase in interest rates to a major decrease in interest rates and vice versa. Even though the optimal interest rate might change dramatically, the inflation response is of only marginal effect.

Optimal interest rate derivatives portfolio with controlled sensitivities

In the interest rate market, the use of derivatives is necessary and can significantly influence the balance sheet of a bank. Moreover, in the light of the recent crisis, it became obvious the need for portfolios with specific and known risk characteristics. This paper proposes a method for constructing optimal portfolios of derivatives with specific risk/return characteristics in the interest rate market. The portfolios can include any interest rate derivative security such as bonds, swaps, caps, floors, swaoptions, CMS, etc. The optimal portfolios will have their risk sensitivities (delta, gamma, theta, etc.) within prespecified bands. In this way, the trade-off between risk and return will be controlled through the life of the portfolio avoiding unwanted risks. The method proposed is structural and dynamic so that it can fit to trading level, risk management level and senior management level. Moreover, the method can include VAR and CVAR techniques which are currently used in risk management.

Money in Monetary Policy Design: Monetary Cross-Checking in the New-Keynesian Model

In the New-Keynesian model, optimal interest rate policy under uncertainty is formulated without reference to monetary aggregates as long as certain standard assumptions on the distributions of unobservables are satisfied. The model has been criticized for failing to explain common trends in money growth and inflation, and that therefore money should be used as a cross-check in policy formulation (see Lucas (2007)). We show that the New-Keynesian model can explain such trends if one allows for the possibility of persistent central bank misperceptions. Such misperceptions motivate the search for policies that include additional robustness checks. In earlier work, we proposed an interest rate rule that is near-optimal in normal times but includes a cross-check with monetary information. In case of unusual monetary trends, interest rates are adjusted. In this paper, we show in detail how to derive the appropriate magnitude of the interest rate adjustment following a significant cross-check with monetary information, when the New-Keynesian model is the central bank's preferred model. The cross-check is shown to be effective in offsetting persistent deviations of inflation due to central bank misperceptions.

On the Optimality of the Friedman Rule with Costly Tax Enforcement

This paper studies the interaction between monetary policy and tax policy in a cash and credit economy when tax enforcement is costly and the set of tax instruments may be incomplete. A positive interest rate and inflation are optimal when enforcement costs are positive and tax enforcement is imperfect. If the government can tax informal workers only imperfectly, it is optimal to increase the inflation tax and deviate from the Friedman rule. Inflation becomes a second best tax due to an imperfect tax system. For a positive detection probability, the Friedman rule can be recovered if monitoring is costless or, equivalently, if evasion penalties are sufficiently high. The optimal interest rate is higher when the government is constrained to set the tax on informal income equal to zero. Our results suggest that the government should tax informal activities heavily to compensate for enforcement expenditures, in accordance with the uniform taxation result.

Openness and interest rates: An analysis using the MIUF model and transaction cost model of money

This paper discusses the manner in which the difference in the specification, which generates a demand for money by agents, alters the optimal interest rate in open economies by taking into account that the prices reflect the producers' optimization. In acanonical money-in-the-utility function (MIUF) model, the Friedman rule is optimal. On the other hand, in the transaction cost model, the optimal interest rate is positive and increases, in terms of the share of imports in consumption.

Optimal Monetary Policy Rules in an Estimated Sticky-Information Model

This paper uses a dynamic stochastic general equilibrium (DSGE) model with sticky information as a laboratory to study monetary policy. It characterizes the model's predictions for macro dynamics and optimal policy at prior parameters, and then uses data on five US macroeconomic series to update the parameters and provide an estimated model that can be used for policy analysis. The model answers a few policy questions. How does sticky information affect optimal monetary policy? What is the optimal interest rate rule? What is the optimal elastic price-level targeting rule? How does parameter uncertainty affect optimal policy? Are the conclusions for the Euro area different? (JEL E13, E31, E43, E52)

Credit Crunches, Collaterals, and Lack of Common Knowledge

Using the global games method, I extend the credit cycles model of Kiyotaki and Moore (1997) in three ways. First, the extended model examines the strategic interactions among monetary authorities, creditors, and an entrepreneur. Second, both creditors and monetary authorities have imperfect information about an entrepreneur's debt as well as the strategic behaviors of other creditors. The strategic behaviors of creditors affect an entrepreneur's collateral value and net worth. This is in contrast to Kiyotaki and Moore's model in which these variables are affected solely by exogenous shocks. Third, monetary authorities play a role in the credit-making decision process in that they can smooth collateral value variability through an optimal interest rate policy. Coordination failures among creditors play though a very important role in the effectiveness of a central bank's attempt to avoid inefficient credit crunches.

Optimal interest rate policy during asset price booms: The mirage of ‘benign neglect’

We show that a policy of ‘benign neglect’ towards an asset price boom is not a sensible option when expectations are forward-looking. Policymakers choose between a policy that cuts real interest rates and one that raises them during asset price booms.

Optimal Rules bagi Instrumen Kebijakan Moneter di Indonesia: Pengujian Empiris Model Guender

This study aims to test model developed by Guender (2002) in determining optimal rules for monetary policy instrument in Indonesia. The test is conducted by estimating parameters of IS equation and Forward Looking Phillips Curve. The result expected is rules for determining the optimal interest rate which is influenced by the gap between actual and targeted inflation. The result shows that in the era of inflation targeting the interest rate setting policy as monetary policy instrument has focus on output stability rather than inflation stability. Finally, the study concludes that the interest rate targeting as BI rate has not being optimal.