Term Structure Rules for Monetary Policy

Computational Economics, 2008

Many proposals are made to extend Taylor rule by including in the optimal reaction function other variables than those originally introduced by Taylor (Discretion versus policy rules in practice, Carnegie-Rochester Conference Series on Public Policy, 1993). The empirical studies point out the importance of long-term interest rates to explain and to forecast the behaviour of the monetary policy control variable. In particular, the positive shocks on long-term interest rates seem to induce a restrictive monetary policy and this finding is explained through the hypothesis that these shocks include the rational expectations on the future inflation rate. McCallum (Federal Reserve of Richmond Economic Quarterly, 91(4), 1-21, 2005) assumes a positive relation between long-term and short-term interest rates to explain the inconsistency of US data with the expectations theory of the interest rate term structure. In this paper a new theoretical model is developed and analysed where the model of Clarida et al. (Journal of Economic Literature, 37(4), 1661-1707 is extended in the above outline of the term structure rational expectations hypothesis and also the dynamics of the nominal long-term interest rate as well as the dynamics of real exchange rate are involved. The optimal reaction function is provided by the algorithm described in Dennis (Journal of Economic Dynamics & Control, 28, 1635-1660 and the empirical impulse response function is obtained by estimating a VAR model.

International Review of Economics & Finance, 2007

We derive necessary and sufficient conditions for simple monetary policy rules that guarantee equilibrium determinacy in the New Keynesian monetary model. Our modeling framework is derived from a fully specified optimization model that is still amenable to analytical characterisation. The monetary rules analyzed are variants of the basic Taylor rules ranging from simple inflation targeting (current, forward, backward), to the canonical Taylor rules with and without inertial nominal interest rate patterns. We establish that determinacy obtains for a wide range of policy parameters, especially when the monetary authority targets output and smoothes interest rates. Contrary to other results in the literature we do not find a case for super-inertial interest rate policy JEL CLASSIFICATION: C62, E40, E52

2005

Using a short-term interest rate as the monetary policy instrument can be problematic near its zero bound constraint. An alternative strategy is to use a long-term interest rate as the policy instrument. We find when Taylor-type policy rules are used to set the long rate in a standard New Keynesian model, indeterminacy-that is, multiple rational expectations equilibria-may often result. However, a policy rule with a long rate policy instrument that responds in a "forward-looking" fashion to inflation expectations can avoid the problem of indeterminacy. * The views expressed herein are those of the authors and do not necessarily reflect those of the Federal Reserve Bank of San Francisco.

2003

This paper proposes a general method for deriving an optimal monetary policy rule in the case of a dynamic linear rational-expectations model and a quadratic objective function for policy. A commitment to a rule of the type proposed results in a determinate equilibrium in which the responses to shocks are optimal. Furthermore, the optimality of the proposed policy rule is independent of the specification of the stochastic disturbances. Finally, the proposed rules can be justified from a "timeless perspective," so that commitment to such a rule need not imply timeinconsistent policy. We show that under fairly general conditions, optimal policy can be represented by a generalized Taylor rule, in which however the relation between the interest-rate instrument and the other target variables is not purely contemporaneous, as in Taylor's specification. We also offer general conditions under which optimal policy can be represented by a "super-inertial" interest-rate rule, and under which it can be represented by a pure "targeting rule" that makes no explicit reference to the path of the instrument.

Recherches économiques de Louvain, 2006

2004

The paper develops an empirical no-arbitrage Gaussian affine term structure model to explain the dynamics of the German term structure of interest rates from 1979 through 1998. In contrast to most affine term structure models two risk factors that drive the dynamics are linked to observable macroeconomics factors: output and inflation. The results obtained by a Kalman-filter-based maximum likelihood procedure indicate that the dynamics of the German term structure of interest rates can be sufficiently explained by expected variations in those macroeconomic factors plus an additional unobservable factor. Furthermore, we are able to extract a monetary policy reaction function within this no-arbitrage model of the term structure that closely resembles the empirical reaction functions that are based on the dynamics of the short rate only.

Spanish Economic Review, 2008

In this paper we estimate a standard version of the New Keynesian Monetary (NKM) model augmented with term structure in order to analyze two issues. First, we analyze the effect of introducing an explicit term structure channel in the NKM model on the estimated parameter values of the model, with special emphasis on the interest rate smoothing parameter using data for the Eurozone. Second, we study the ability of the model to reproduce some stylized facts such as highly persistent dynamics, the weak comovement between economic activity and inflation, and the positive, strong comovement between interest rates observed in actual Eurozone data. The estimation procedure implemented is a classical structural method based on the indirect inference principle.

SSRN Electronic Journal, 2000

Monetary economists have recently begun a serious study of money supply rules that allow the Fed to adjustably peg the nominal interest rate under rational expectations. These rules vary from procedures that produce stationary nominal magnitudes to those that generate nonstationarities in nominal variables. Our paper investigates the determinacy properties of three representative interest rate rules. We use Blanchard and Kahn's solution technique as a starting point. It doesn't directly apply, so we first modify their procedure. We then narrow the range of solutions by considering the ARMA solutions of Evans and Honkapohja and the global minimum state variable solution of McCallum. We then examine these solutions in light of the expectational stability notions emplayed by DeCanio, Bray and Evans. Two of the three classes of rules yield a unique admissible solution. The exclusion of bubbles usually rules out the general ARMA solutions present in Evans and Honkapohja and leads to unique solutions via a saddlepoint property. Nonetheless, the nonstationary money supply rules we examine do not generally yield a well determined system over all parameter values. We employ the global minimum state variable methodology of Mc-Callum and Evans' expectational stability in an effort to insure uniqueness. Although these methods are usually in agreement, one of the nonstationary rules yields a global minimum state variable solution that is expectationally unstable when the central bank is sensitive to interest rate deviations. Moreover, under these conditions, an alternative (non-global) minimum state variable solution is expectationally stable, casting doubt on the applicability of McCallum's global procedure in thii context.

2008

Recent macroeconomic literature stressed the importance of expectations heterogeneity in the formulation of monetary policy. We use a stylized macro model of Howitt (1992) to investigate the dynamical consequences of alternative interest rate rules when agents have heterogeneous expectations and update their beliefs over time along the lines of Brock and Hommes (1997).

Journal of Economic Behavior & Organization, 2001

In the framework of a Keynesian based monetary macro model, we study the implications of targeting monetary aggregates or targeting the interest rate as two alternative monetary policy rules. Whereas the former targets the inflation rate indirectly, through the control of the money supply, the ...