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A case for interest rate smoothing

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  • Bask, Mikael

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.

Suggested Citation

  • Bask, Mikael, 2007. "A case for interest rate smoothing," Bank of Finland Research Discussion Papers 25/2007, Bank of Finland.
    • Handle: RePEc:zbw:bofrdp:rdp2007_025
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    References listed on IDEAS

    as
    1. Richard Clarida & Jordi Galí & Mark Gertler, 2000. "Monetary Policy Rules and Macroeconomic Stability: Evidence and Some Theory," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 115(1), pages 147-180.
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    3. Lubik, Thomas A. & Schorfheide, Frank, 2007. "Do central banks respond to exchange rate movements? A structural investigation," Journal of Monetary Economics, Elsevier, vol. 54(4), pages 1069-1087, May.
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    More about this item

    Keywords

    determinacy; E-stability; foreign exchange; inertia; Taylor rule;
    All these keywords.

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • F31 - International Economics - - International Finance - - - Foreign Exchange

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