NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Optimal Monetary Policy Inertia

Michael Woodford

NBER Working Paper No. 7261
Issued in July 1999
NBER Program(s):   EFG   ME

This paper considers the desirability of the observed tendency of central banks to adjust interest rates only gradually in response to changes in economic conditions. It shows, in the context of a simple model of optimizing private-sector behavior, that such inertial policy can be optimal. The reason is that small but persistent changes in short-term interest rates in response to shocks allow a larger effect of monetary policy on long rates and hence upon aggregate demand, for a given degree of overall interest-rate variability. The paper also considers two ways of achieving the desirable degree of inertia in the equilibrium responses to shocks. One is by assignment of a loss function that penalizes squared interest-rate changes (despite the fact that interest-rate changes do not affect the true social objective) to a central bank that is then expected to use discretion in the pursuit of the goal. The second is through commitment to an explicit instrument rule, a generalization of the Taylor rule' in which the funds rate is an increasing function of the lagged funds rate, as in estimated Fed reaction functions.

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Document Object Identifier (DOI): 10.3386/w7261

Published:

  • The Manchester School, Vol. 67, Supplement S1 (1999): 1-35 ,
  • Michael Woodford, 1999. "Optimal monetary policy inertia," Proceedings, Federal Reserve Bank of San Francisco.

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