Research Discussion Papers, Bank of Finland
A case for interest rate smoothing
Abstract: The aim of this paper is to determine whether it would be
desirable from the perspective of macroeconomic balance for central banks
to take account of nominal exchange rate movements when framing monetary
policy. The theoretical framework is a small, open DSGE economy that is
closed by a Taylor rule for the monetary authority, and a determinate REE
that is least-squares learnable is defined as a desirable outcome in the
economy. When the policy rule contains contemporaneous data on the output
gap and the CPI inflation rate, the monetary authority does not have to
consider the exchange rate as long as there is sufficient inertia in
policy-making. In fact, due to a parity condition on the international
asset market, interest rate smoothing and a response to changes in the
nominal exchange rate are perfectly intersubstitutable in monetary policy.
In other words, we give a rationale for the monetary authority to focus on
the change in the nominal interest rate rather than its level in
policy-making. Thus, we have a case for interest rate smoothing.
Keywords: determinacy; E-stability; foreign exchange; inertia; Taylor rule; (follow links to similar papers)
JEL-Codes: E52; F31; (follow links to similar papers)
25 pages, December 19, 2007
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