A case for interest rate smoothing

The aim of this paper is to determine whether it would be desirable from the perspective of macroeconomic balance for central banks to take account of nominal exchange rate movements when framing monetary policy. The theoretical framework is a small, open DSGE economy that is closed by a Taylor rule for the monetary authority, and a determinate REE that is least-squares learnable is defined as a desirable outcome in the economy. When the policy rule contains contemporaneous data on the output gap and the CPI inflation rate, the monetary authority does not have to consider the exchange rate as long as there is sufficient inertia in policy-making. In fact, due to a parity condition on the international asset market, interest rate smoothing and a response to changes in the nominal exchange rate are perfectly intersubstitutable in monetary policy. In other words, we give a rationale for the monetary authority to focus on the change in the nominal interest rate rather than its level in policy-making. Thus, we have a case for interest rate smoothing.

Introduction: It is argued in Taylor (2001) that it is not necessary to react to movements in exchange rates in monetary policy to haveadesirableoutcomeintheeconomy. Taylor’s (2001) argument is that the indirect effects that exchange rates have on monetary policy, via its effects on output and the inflation rate, are to prefer since it results in fewer and less erratic changes in the nominal interest rate. In this paper, we re-examine the question whether one should respond to nominal exchange rate movements in policy-making by embedding two specifications of an interest rate rule into a small open economy, where we include an exchange rate term in the policy-rules. In the first rule, contemporaneous data on the output gap, the CPI inflation rate and the nominal exchange rate change are included, whereas, in the second rule, forward expectations of the same variables are included in the rule.

Author: Mikael Bask

Source: Research Discussion Papers, Bank of Finland

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