Optimal Interest Rate Research Articles

Heterogeneous Information About the Term Structure of Interest Rates, Least-Squares Learning and Optimal Interest Rate Rules for Inflation Targeting

In this paper we incorporate the term structure of interest rates in a standard inflation forecast targeting framework.Learning about the transmission process of monetary policy is introduced by having heterogeneous agents - i.e. the central bank and private agents - who have different information sets about the future sequence of short-term interest rates.We analyse inflation forecast targeting in two environments.One in which the central bank has perfect knowledge, in the sense that it understands and observes the process by which private sector interest rate expectations are generated, and one in which the central bank has imperfect knowledge and has to learn the private sector forecasting rule for short-term interest rates.In the case of imperfect knowledge, the central bank has to learn about private sector interest rate expectations, as the latter affect the impact of monetary policy through the expectations theory of the term structure of interest rates.Here following Evans and Honkapohja (2001), the learning scheme we investigate is that of least-squares learning (recursive OLS) using the Kalman filter.We find that optimal monetary policy under learning is a policy that separates estimation and control.Therefore, this model suggests that the practical relevance of the breakdown of the separation principle and the need for experimentation in policy may be limited.

Dynamics of the federal funds target rate: a nonstationary discrete choice approach

AbstractWe apply a discrete choice approach to model the empirical behaviour of the Federal Reserve in changing the federal funds target rate, the benchmark of short‐term market interest rates in the US. Our methods allow the explanatory variables to be nonstationary as well as stationary. This feature is particularly useful in the present application as many economic fundamentals that are monitored by the Fed and are believed to affect decisions to adjust interest rate targets display some nonstationarity over time. The chosen model successfully predicts the majority of the target rate changes during the time period considered (1994–2001) and helps to explain strings of similar intervention decisions by the Fed. Based on the model‐implied optimal interest rate, our findings suggest that there is a lag in the Fed's reaction to economic shocks during this period. Copyright © 2004 John Wiley & Sons, Ltd.

Economic structure, policy objectives, and optimal interest rate policy at low inflation rates

In this article, the optimal interest-rate rule generated by Svensson’s (1997) dynamic model is used to determine the impact of a number of key structural characteristics on the downward flexibility of interest rates at low rates of inflation. The potential impact of preferences for inflation stability, relative to output stability on the monetary authority’s ability to use expansionary interest-rate policy is also considered. Estimates of the model for six countries provide evidence of the quantitative significance of the theoretical results. The empirical results are used to identify which monetary authorities are likely to be the most severely constrained in the event of an economic downturn. The size of the contraction that would be required for the interest-rate constraint to bind is estimated for each country in the sample.

Friedman's Money Supply Rule vs Optimal Interest Rate Policy

Using New Keynesian models, we compare Friedman's k-percent money supply rule to optimal interest rate setting, with respect to determinacy, stability under learning and optimality.We first review the recent literature.Open-loop interest rate rules are subject to indeterminacy and instability problems, but a properly chosen expectations-based rule yields determinacy and stability under learning, and implements optimal policy.We then show that Friedman's rule also can generate equilibria that are determinate and stable under learning.However, in computing the mean quadratic welfare loss, we find that for calibrated models Friedman's rule performs poorly compared to the optimal interest rate rule. Key words: monetary policy, determinacy, stability under learning JEL classification numbers: E52, E31

Robust European monetary policy rules

This note applies H ∞ methods to an estimated hybrid monetary policy model and derives standard and robust optimal interest rate rules. We find that the ‘robust’ central banker responds more aggressively than it does without concerns for robustness and that the responses of the state variables in this case are not necessarily always stronger than the standard ones.

Friedman's Money Supply Rule vs. Optimal Interest Rate Policy

AbstractUsing New Keynesian models, we compare Friedman's k‐percent money supply rule to optimal interest rate setting, with respect to determinacy, stability under learning and optimality. First we review the recent literature: open‐loop interest rate rules are subject to indeterminacy and instability problems, but a properly chosen expectations‐based rule yields determinacy and stability under learning, and implements optimal policy. We show that Friedman's rule also can generate equilibria that are determinate and stable under learning. However, computing the mean quadratic welfare loss, we find for calibrated models that Friedman's rule performs poorly when compared to the optimal interest rate rule.

Robust European Monetary Policy Rules

This note applies H-infinite methods to an estimated hybrid monetary policy model (cf. Sahuc, Applied Economics Letters, 9, pp. 949-55, 2002) and derives standard and optimal interest rate rules. We find that the robust central banker responds more aggressively than it does without concerns for robustness and that the responses of the state variables in this case are not necessarily always stronger than the standard ones.

The BMW Model: Simple Macroeconomics for Closed and Open Economies - A Requiem for the IS/LM-AS/AD and the Mundell-Fleming Model

While the IS/LM-AS/AD model is still the central tool of macroeconomic teaching in most macroeconomic textbooks, it has been criticised by several economists. Colander [1995] has demonstrated that the framework is logically inconsistent, Romer [2000] has shown that it is unable to deal with a monetary policy that uses the interest rate as its operating target, Walsh [2001] has criticised that it is not well suited for an analysis of inflation targeting. In our paper we start with a short discussion of the main flaws of the IS/LM-AS/AD model. We present the BMW model as an alternative framework, which develops the Romer approach into a very simple, but comprehensive macroeconomic model. In spite of its simplicity it can deal with issues like inflation targeting, monetary policy rules, and central bank credibility. We extend the model to an open-economy version as a powerful alternative to the IS/LM-based Mundell-Fleming (MF) model. The main advantage of the open-economy BMW model is its ability to discuss the role of inflation and the determination of flexible exchange rates while the MF model is based on fixed prices and constant exchange rates. This working paper is an extended and more theoretical version of Wurzburg Economic Paper No. 34. Besides describing the derivation of optimal interest rate rules and the concept of loss functions more in detail, it also discusses simple interest rate rules in an open economy as well as a strategy of managed floating within the same theoretical framework. Additionally, we explore the stabilizing properties of simple interest rate rules.

Optimal Loan Interest Rate Contract Design

This paper analyzes optimal loan interest rate contracts under conditions of risky, symmetric information for one-period (static) and multi-period (dynamic) models. The optimal loan interest rate depends upon the volatility of, and co-variation among the market interest rate, borrower collateral, and borrower income, as well as the time horizon and the risk preferences of lenders and borrowers. For a risk-averse borrower with stochastic collateral, variable interest rate contracts are, in general, Pareto optimal. For plausible assumptions, the optimal loan interest rate for the multi-period model often exhibits “muted” responses to changes in market interest rates, making fixed rate loans a reasonable approximation for the optimal loan. Hence, in the absence of optimal contracts, long-term (short-term) borrowers tend to prefer fixed rate (variable) contracts.

Estimation and control of an optimization-based model with sticky prices and wages

This paper provides estimates of an optimization-based equilibrium model with sticky prices and wages. The estimated model is used to analyse the welfare properties of various interest rate rules for conducting monetary policy. An important feature of this model is that it involves a tradeoff between the variances of price and wage inflation and the output gap. This tradeoff implies that it is desirable for the monetary authority to respond to wage inflation, in addition to price inflation, output, and past interest rates, when setting the current interest rate. The issue whether wages and prices can be indexed to steady-state inflation has important implications both for the characterization of optimal interest rate rules and interest rate volatility. In particular, optimal policy in the presence of indexation induces implausibly high steady-state inflation.

Optimal Interest Rate Rules in Inflation Targeting Frameworks

This work describes the main characteristics of an inflation targeting regime and derives the optimal solution for interest rates according to an original methodology for two models based on the Phillips and IS curves containing general exogenous variables and a complete loss-function.

Delaying the Inevitable: Optimal Interest Rate Policy and BOP Crises

The classical model of balance of payments crises implicitly assumes that the central bank sits passively as international reserves dwindle. In practice, however, central banks typically defend pegs aggressively by raising short-term interest rates. This paper analyzes the feasibility and optimality of raising interest rates to delay a potential BOP crisis. Interest rate policy works through two distinct channels. By raising demand for domestic, interest-bearing liquid assets, higher interest rates tend to delay the crisis. Higher interest rates, however, increase public debt service and imply higher future inflation, which tends to bring forward the crisis. We show that, under certain conditions, it is feasible to delay the crisis, but raising interest rates beyond a certain point may actually hasten the crisis. A similar non-monotonic relationship emerges between welfare and the increase in interest rates. It is thus optimal to engage in some active interest rate defense but only up to a certain point. In fact, there is a whole range of interest rate increases for which it is feasible to delay the crisis but not optimal to do so.

A simple model of monetary policy and currency crises

This paper analyzes the optimal interest rate policy in currency crises. Firms are credit constrained and have debt in domestic and foreign currency, a situation that may easily lead to a currency crisis. An interest rate increase has an ambiguous effect on firms since it makes more difficult to borrow and may decrease the foreign currency debt burden. In some cases it is actually best to decrease the interest rate. We also show how these issues are related to the development of the financial system.

Should Uncertain Monetary Policy-Makers Do Less?

This paper examines the empirical importance of parameter uncertainty for monetary policy-making in the United Kingdom, using a method pioneered by Brian Sack of the U.S. Federal Reserve. Using a VAR model of the U.K. economy and an assumed quadratic loss function for the policy-maker, an optimal interest rate rule is calculated first ignoring parameter uncertainty, then assuming that the parameter uncertainty is given by the estimated standard errors on the VAR coefficients. These rules are compared with the estimated interest rate equation from the VAR. The optimal rule accounting for parameter uncertainty results in a less aggressive path for official interest rates than when parameter uncertainty is ignored. However, the estimates of parameter uncertainty are not so large that the optimal rule matches all the characteristics of the actual path of official rates.

Modeling and Identifying Central Banks' Preferences

In this paper we propose an approach to identify indipendently the parameters describing the structure of the economy from the parameters describing central bank preferences. We first estimate the parameters describing the structure of the US economy by considering a parsimonious specification for inflation, the output-gap and the commodity price index. We then proceed to the identification of central bank preferences by estimating by GMM the Euler equations for the solution of the intertemporal optimization problem relevant to the central banker. We then compare optimal and actual interest rate behavior to select a structure of central bank's preferences. Our main results are as follows. First, persistence in interest rates could be explained by the structure of the economy. Second, strict inflation targeting dominates flexible inflation targeting. Third, the actual behavior of the policy rates cannot be described by the pure strict inflation targeting model, which would imply a much more aggressive monetary policy than the observed one. Fourth, when the inflation targeting model is extended to consider Brainard-type uncertainty and real interest rates smoothing, the latter is preferred hypothesis to reconcile actual and optimal interest rates behavior.

Sustained endogenous growth with decreasing returns and heterogeneous capital

Abstract The possibility of sustained long-run growth is typically associated with the presence of some endogenous `engine of growth'. It may allow the economy to grow without bound despite the use of some non-reproducible resources. Such situations can lead to dynamic models combining the features of sustainable growth and decreasing returns. One-sector models of this kind have recently attracted much attention in macroeconomics applications. Their approximate linearity for the purposes of long-run analysis has been noted. This paper is aimed at establishing the general fact: dynamic models (one- or multi-sector) which are characterized by sustained endogenous growth with non-increasing returns display the patterns of optimal growth asymptotically equivalent to those generated by models with linear technology. I consider a neoclassical growth model with heterogeneous capital, develop its linear counterpart, and prove their asymptotic equivalence in terms of long-run optimal growth rates and cross-sectoral profiles of consumption, real interest rates and relative prices. This result also implies the `non-substitution' theorem for the neoclassical dynamic model of sustained growth: optimal input profiles, relative prices, and interest rates are asymptotically independent of intertemporal preferences.

Informational Efficiency, Interest Rate Variability, and Central Bank Operations

It is shown how the frequency of central bank intervention in financial markets can affect the incentives for economic agents to acquire information, which will be reflected in market prices and thus become available to policy makers. The optimal frequency of intervention, and therefore the optimal interest rate variability, will balance the desirability of attaining given operational targets against the benefits of encouraging informational efficiency. The ability of the central bank to send clear signals of its own intentions will also depend on market informational efficiency.

Optimal government finance policy and exchange rate management in a stochastically growing open economy

Optimal monetary policy is analyzed in a stochastic small open economy, consisting of risk averse representative agents. The analysis shows how optimal monetary policy should be directed toward an optimal interest rate target. This target, which maximizes the intertemporal utility of the representative agent, is determined by balancing off the marginal gains of a higher interest rate on increased growth and the future consumption it generates, against the marginal losses stemming from a reduction in the holdings of real money balances. The paper shows how an appropriately set monetary growth rate eliminates the need for continuous intervention in the exchange market.

OPTIMAL INCOME TAXATION, DYNAMIC EFFICIENCY, AND THE SOCIAL COST OF PUBLIC EXPENDITURE

An interest income tax and a publicly provided private good are introduced into the Hamada overlapping-generations model consisting of heterogeneous individuals where the government can use a wage-income tax, an identical lump-sum transfer, and the public debt. Two interesting problems are studied: (a) what relation exists between the optimal interest rate and the population-growth rate and (b) how dynamic efficiency affects the optimal-decision rules of taxes and the publicly provided good. We show that (i) if the government can (not) tax the interest income, then the optimal interest rate is (not) equal to the population-growth rate, (ii) without the availability of the interest tax the difference between these two rates is mainly caused by the income-distribution effect of the public debt and (iii) the dynamic efficiency effects on the optimal rules of the wage tax and the publicly provided good depend on not only such a difference but also the average substitute-complement relations among leisure, the second-period consumption and the publicly provided good.

An Optimal Interest Rate Rule with Information from Money and Auction Markets

For an economy characterized by neo-Keynesian wage rigidity, an optimal open market rule is derived based on financial market information, including auction price behavior. Simulations of a small model of the United States--estimated via full information maximum likelihood together with a numerical procedure for solving dynamic, linear rational expectations models--are used to evaluate the response of the economy to sectoral shocks, given the optimal interest rate rule. In the case of three aggregate commodity price indexes studied here, the additional indicator information is unlikely to have significant impact on the performance of monetary policy. Copyright 1994 by Ohio State University Press.