url
12
Jul
2014

SIMPLE MONETARY POLICY RULES UNDER MODEL UNCERTAINTY: Comparison of Alternative Simple Rules 3

Although empirical evidence reveals a pattern of interest rate smoothing in many industrial countries and is a property of the estimated U.S. interest rate rule in equation (1), the normative case for interest rate smoothing has remained much less clear.19 Lowe and Ellis (1997) have recently surveyed the literature and summarized several considerations that tend to favor interest rate smoothing. One argument, advanced by Goodfriend (1991) and others, is particularly relevant to our analysis: smooth changes in the short-term interest rate provide greater control over long-term interest rates and thereby greater control over aggregate demand and inflation.

This rationale is explicitly captured in the four rational expectations models considered here: in each model, monetary policy stabilizes output and inflation mainly through its influence on the long-term real interest rate, which is determined as a weighted average of current and expected future short-term rates21 Thus, since the federal funds rate is more persistent under the smoothing rule compared with the level rule, a given initial adjustment of the federal funds rate induces a larger movement in the long-term bond rate and thereby achieves more rapid stabilization of output and inflation.

To evaluate the role of this mechanism in explaining the superior performance of interest rate smoothing rules, we conduct counterfactual experiments in each of the two smaller models, FM and MSR. In particular, we shorten the duration of the term structure equation, and compute new constrained output/inflation volatility frontiers based on rules with three parameters. In the FM model, we replace the 30-year bond rate with the current short-term rate in the IS curve.

Although empirical evidence reveals a pattern of interest rate smoothing in many industrial countries and is a property of the estimated U.S. interest rate rule in equation (1), the normative case for interest rate smoothing has remained much less clear.19 Lowe and Ellis (1997) have recently surveyed the literature and summarized several considerations that tend to favor interest rate smoothing. One argument, advanced by Goodfriend (1991) and others, is particularly relevant to our analysis: smooth changes in the short-term interest rate provide greater control over long-term interest rates and thereby greater control over aggregate demand and inflation. This rationale is explicitly captured in the four rational expectations models considered here: in each model, monetary policy stabilizes output and inflation mainly

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Kevin J. Brandon

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