The Optimal Form of Interest Rate Targeting
28 Pages Posted: 4 Mar 1999
Date Written: December 8, 1998
Most central banks currently implement monetary policy by targeting a short-term interest rate. This paper asks: "What is the optimal form for such interest rate targeting, given the objectives facing central banks?" We find the optimal rule is for the central bank to change the target rate whenever the deviation between its preferred rate and the current target rate reaches some critical level, and in this case the target rate is changed by a discrete amount in the direction of its preferred rate. Despite the simplicity of this rule, we are able to replicate a number of puzzling features of interest rate targeting observed in practice. Hazard functions of target changes are constructed and comparative static results evaluated, using the model calibrated to United States data.
JEL Classification: E43, E52, E58
Suggested Citation: Suggested Citation