Monetary Stabilization with Interest Rate Instruments in Japan: A Linear Quadratic Control Analysis

This paper examines the relation between alternative objectives for interest rate rules in the conduct of monetary policy, and the volatility of asset prices, the exchange rate, and the M2 monetary aggregate, as well as output and inflation. We make use of a small econometric model with unexpected oil price and foreign output shocks, simulation analysis, and stochastic control methods based on linear quadratic loss functions with state-space constraints. Our results show the stabilizing powers of a systematic feedback policy for the call rate. Whether the Bank of Japan follows a broad-based multivariate target, or specific targets, such as the exchange rate or asset prices, a feedback control policy succeeds in reducing the variability of all of the macroeconomic variables, relative to a base path in which the call rate simply followed a stochastic autoregressive process. Results based on 1,000 repeated of stochastic simulations indicate, however, that the greatest gains for all variables with call-rate feedback policy come from exchange rate targeting or broadbased targeting rather than broad money or inflation targeting.