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Designing instrument rules for monetary stability: the optimality of interest-rate smoothing

Designing instrument rules for monetary stability: the optimality of interest-rate smoothing
Designing instrument rules for monetary stability: the optimality of interest-rate smoothing
A key issue in monetary policy is that on the importance of following systematic behaviours. The paper revisits the classic debate on rules versus discretion focusing on the design of instrument rules in a manner that push discretionary policy choices in the direction of the commitment equilibrium. It is shown that an instrument rule with an optimal degree of monetary inertia may render negligible the inflationary bias associated with discretion without necessarily implying a trade-off between flexibility and commitment. The rationale for this surprising finding is found in the disciplining effect played by interest-rate smoothing on the incentive to create surprise inflation by reducing suddenly the interest rate within the time horizon of existing nominal contracts. If the degree of gradualism is high it may enhance the credibility of optimal monetary policy as it contrasts the incentive to fool private sector.
monetary policy, instrument rules, commitment, discretion, interest-rate smoothing, delegation
8
University of Southampton
Rotondi, Zeno
0b11b824-ceb6-4392-b8f1-0ee03cd4f42a
Rotondi, Zeno
0b11b824-ceb6-4392-b8f1-0ee03cd4f42a

Rotondi, Zeno (2000) Designing instrument rules for monetary stability: the optimality of interest-rate smoothing (Discussion Papers in Economics and Econometrics, 8) Southampton, UK. University of Southampton 38pp.

Record type: Monograph (Discussion Paper)

Abstract

A key issue in monetary policy is that on the importance of following systematic behaviours. The paper revisits the classic debate on rules versus discretion focusing on the design of instrument rules in a manner that push discretionary policy choices in the direction of the commitment equilibrium. It is shown that an instrument rule with an optimal degree of monetary inertia may render negligible the inflationary bias associated with discretion without necessarily implying a trade-off between flexibility and commitment. The rationale for this surprising finding is found in the disciplining effect played by interest-rate smoothing on the incentive to create surprise inflation by reducing suddenly the interest rate within the time horizon of existing nominal contracts. If the degree of gradualism is high it may enhance the credibility of optimal monetary policy as it contrasts the incentive to fool private sector.

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More information

Published date: 2000
Additional Information: JEL classification: E52, E58
Keywords: monetary policy, instrument rules, commitment, discretion, interest-rate smoothing, delegation

Identifiers

Local EPrints ID: 33112
URI: https://eprints.soton.ac.uk/id/eprint/33112
PURE UUID: 0f3bf59c-0802-4996-bb36-04205c34acaf

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Date deposited: 19 Jul 2006
Last modified: 17 Jul 2017 15:54

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