Optimal Monetary Policy and Term Structure in a Continuous-Time DSGE Model

49 Pages Posted: 29 Nov 2016 Last revised: 17 Feb 2019

See all articles by Haitao Li

Haitao Li

University of Michigan - Stephen M. Ross School of Business; Cheung Kong Graduate School of Business; Cheung Kong Graduate School of Business

Tao Li

City University of Hong Kong (CityU) - Department of Economics & Finance

Cindy Yu

Iowa State University

Date Written: February 15, 2019

Abstract

We study optimal monetary policy, macro dynamics and their implications on the term structure of interest rates in a continuous-time New-Keynesian model. With a quadratic cost function and regime-dependent monetary discount rates, the time-consistent optimal monetary policy is regime-dependent linear interest rate rules in inflation and output gaps. This optimal interest rate rule converges to zero if monetary authority extremely concerns immediate macro stability. The optimal interest rate rules and the equilibrium dynamics of inflation and output gap form a regime-dependent term structure model. We take the model to the US data and find that the Fed had followed two distinct interest rate rules during 1952-2007, the near-optimal one is more stabilizing than the non-optimal one.

Keywords: Optimal monetary policy, Taylor rule, Term structure of interest rates, New Keynesian, Macroeconomic stability

JEL Classification: C11, C62, E43, E52, G12

Suggested Citation

Li, Haitao and Li, Tao and Yu, Cindy, Optimal Monetary Policy and Term Structure in a Continuous-Time DSGE Model (February 15, 2019). Available at SSRN: https://ssrn.com/abstract=2876215 or http://dx.doi.org/10.2139/ssrn.2876215

Haitao Li

University of Michigan - Stephen M. Ross School of Business ( email )

701 Tappan Street
Ann Arbor, MI MI 48109
United States
734-615-5475 (Phone)

Cheung Kong Graduate School of Business ( email )

Oriental Plaza, Tower E3
One East Chang An Avenue
Beijing, 100738
China

Cheung Kong Graduate School of Business ( email )

Oriental Plaza, Tower E3
One East Chang An Avenue
Beijing, 100738
China

Tao Li (Contact Author)

City University of Hong Kong (CityU) - Department of Economics & Finance ( email )

83 Tat Chee Avenue
Kowloon
Hong Kong

Cindy Yu

Iowa State University ( email )

613 Wallace Road
Ames, IA 50011
United States

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