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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

Abstract: 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)
Date: 2017-02
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