SSE/EFI Working Paper Series in Economics and Finance
Reaction Function Estimation when Central Banks Face Adjustment Costs
Abstract: The main instrument of monetary policy in industrialized
countries is currently a short-term interest rate. It typically remains
unchanged during long spans of time. This paper tries to answer three
questions. Why do Central Banks change targeted interest rates so seldom?
How should we estimate Central banks' reaction functions? And what are the
driving forces behind rate changes? This paper takes the point of view that
Central Banks face a fixed cost when adjusting the targeted interest rate
and therefore smoothe the targeted interest rate by using a discrete policy
rule. In the estimation of the reaction function this discrete nature is
taken into account by applying a grouped data model to a Swedish data set.
It is found that the reaction function is best represented in terms of
changes in growth rates of macro variables and changes in levels of
financial variables. Probabilities of the target rate being raised, lowered
or kept constant are computed and compared with actual interest rate
behavior. The model has a prediction rate of 88% versus 78% for the best
JEL-Codes: C35; E43; E52; E58; (follow links to similar papers)
28 pages, January 1997
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