Monetary Policy, Interest Rate Rules, and Inflation Targeting: Some Basic Equivalences / Carlos A. Vegh.

By:

Vegh, Carlos A

Contributor(s):

National Bureau of Economic Research

Material type: Text

TextSeries: Working Paper Series (National Bureau of Economic Research) ; no. w8684.Publication details: Cambridge, Mass. National Bureau of Economic Research 2001.Description: 1 online resource: illustrations (black and white)Subject(s):

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Abstract: Policymakers increasingly view short-term nominal interest rates as the main instrument of monetary policy, often in conjunction with some inflation target. Interest rates on short-term indexed government debt (i.e., a real interest rate) have also been used as policy instruments. To understand the pros and cons of different policy rules and instruments, this paper derives some basic equivalences among different policy rules. It is shown that, under certain conditions, the following three rules are exactly equivalent: (i) a 'k-percent' money growth rule; (ii) a nominal interest rate rule combined with an inflation target; and (iii) a real interest rate rule combined with an inflation target. These policy rules, however, become increasingly complex: the first rule requires no feedback mechanism; the second rule requires responding to the inflation gap; while the third rule involves responding to both the inflation gap and the output gap. It is also shown that policy rules which respond to the output gap may avoid a deflationary adjustment.

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December 2001.

Policymakers increasingly view short-term nominal interest rates as the main instrument of monetary policy, often in conjunction with some inflation target. Interest rates on short-term indexed government debt (i.e., a real interest rate) have also been used as policy instruments. To understand the pros and cons of different policy rules and instruments, this paper derives some basic equivalences among different policy rules. It is shown that, under certain conditions, the following three rules are exactly equivalent: (i) a 'k-percent' money growth rule; (ii) a nominal interest rate rule combined with an inflation target; and (iii) a real interest rate rule combined with an inflation target. These policy rules, however, become increasingly complex: the first rule requires no feedback mechanism; the second rule requires responding to the inflation gap; while the third rule involves responding to both the inflation gap and the output gap. It is also shown that policy rules which respond to the output gap may avoid a deflationary adjustment.