Interest Rate in the Objective Function of the Central Bank and Monetary Policy Design
Guy Segal ()
No 2017.02, Bank of Israel Working Papers from Bank of Israel
We analyze two well-known specifications of the interest rate term in the central bank's objective function, and find that the inflation response to a positive demand shock is positive (intuitive) under one specification and negative (counter-intuitive) under the other. We show that the difference between the two responses can be mitigated by a Taylor-type rule and depends on the interest rate inertia. A super-inertial interest rate, which is more aggressive and leads to the counter-intuitive response, may be helpful in an environment of low inflation due to negative demand shocks, such as the current global economic environment.
Keywords: Interest rate smoothing; super inertial; optimal monetary policy (search for similar items in EconPapers)
JEL-codes: E58 E61 (search for similar items in EconPapers)
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