On measuring the nonlinear effect of interest rates on inflation and output

Hyeong Ho Moon, Tae-Hwan Kim () and Seongho Nah
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Hyeong Ho Moon: Department of Economics, University of California at San Diego, USA
Seongho Nah: Bank of Korea, South Korea

No 2013rwp-53, Working papers from Yonsei University, Yonsei Economics Research Institute

Abstract: While economists are interested in the reaction of the interest rate to changes in the inflation rate, central bankers are usually more interested in the reverse causal relationship, i.e., the response of inflation (and output) to a change in the official interest rate as administrated by the central bank. Whether the reverse causal relationship is linear or nonlinear is an empirical issue. We investigated the reverse causal relationship by employing the LSTVAR model proposed by Weise (1999). We found strong evidence in favor of nonlinearity. As a consequence of the nonlinearity, we discovered various types of asymmetric effects of the interest rate on inflation and output. An asymmetric effect of monetary shocks of different sizes was uncovered, which implies that when the unexpected change in the official rate is doubled (i.e. from 0.25% to 0.5%), its effect on inflation and output is likely to be more than doubled. However, this finding is upheld only when the economy is in recession. The opposite result, in which the effect is smaller, is supported when the economy is expanding. Regarding the other asymmetric effect of monetary shocks with different signs, we found that central banks can expect that increasing the official rate by some certain amount (e.g. 0.25%) is likely to have much larger effect on inflation and output than decreasing the rate by the same amount (e.g. -0.25%) regardless of the state of the economy.

Keywords: Nonlinear VAR; impulse response function; asymmetric monetary effect (search for similar items in EconPapers)
JEL-codes: E43 E58 (search for similar items in EconPapers)
Pages: 22 pages
Date: 2012-02-13
New Economics Papers: this item is included in nep-cba, nep-mac and nep-mon
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