IMPLICATIONS FOR THE MACRO-ECONOMY OF THE CENTRAL BANK ADOPTING AN INTEREST RATE RULE

Implications for the macro-economy of the central bank adopting an interest rate rule

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Abstract

In this paper we analyze equilibrium determinacy in a sticky price model in which the pass-through from policy rates to retail interest rates is sluggish and potentially incomplete. In addition, we empirically characterize and compare the interest rate pass-through process in the euro area and the U.S. We find that if the pass-through is incomplete in the long run, the standard Taylor principle is insufficient to guarantee equilibrium determinacy. Our empirical analysis indicates that this result might be particularly relevant for bank-based financial systems as for instance that in the euro area.

Table of Contents

Abstract2

Chapter I4

1. Introduction4

Chapter II8

2. Taylor Rule:8

3. Model9

Chapter III15

4. Interest rate pass-through and determinacy15

Chapter IV19

5. Empirical analysis19

5.1. Data20

5.2. Long-run pass-through23

Chapter V35

6. Discussion35

Chapter VI38

7. Concluding remarks38

Appendix- Regression Analysis39

References44

Chapter I

1. Introduction

The stability properties associated with monetary policy rules have attracted a substantial amount of attention. In principle, monetary policy rules give rise to a determinate equilibrium if the implied response to inflation is sufficiently strong. To avoid indeterminacy, nominal interest rates have to respond sufficiently to an increase in inflation to raise the real interest rate. Hence, the nominal rate has to respond at least one-for-one to changes in the (expected) inflation rate to guarantee a unique and stable equilibrium. This result is referred to as the Taylor principle (Woodford, 2003). Otherwise, the equilibrium is indeterminate and fluctuations resulting from self-fulfilling revisions in expectations become possible. Intuitively, if nominal rates do not adjust sufficiently, a rise in expected inflation leads to a decrease in the real interest rate, which stimulates aggregate demand. Higher aggregate demand results in an increase in inflation, and consequently the initial expectation is confirmed. Several studies argue that the comparatively successful conduct of monetary policy since the early 1980s is primarily due to the implementation of an appropriate policy rule, that is, a rule that satisfies the Taylor principle (see e.g. [Judd and Rudebush, 1998], [Taylor, 1999], [Clarida et al., 1998] and [Clarida et al., 2000]).2

Empirically it appears that retail interest rates respond less than one-for-one to policy rates (e.g. [Cottarelli and Kourelis, 1994], [Borio and Fritz, 1995], [Moazzami, 1999], [Hofmann and Mizen, 2004], [Sander and Kleimeier, 2004], [De Bondt, 2005] and [Kok Sorensen and Werner, 2006]). Moreover, retail interest rates are likely to influence aggregate demand. Thus, it seems conceivable that although monetary policy is tightened sufficiently, obeying the Taylor principle, retail interest rates do not respond sufficiently to ensure that real rates are stabilizing. This appears to be particularly relevant for the euro area, which is generally thought to be an example of a bank-based financial system (Allen and Gale, 2000).

In the present paper we analyze the stability properties of a simple sticky price model in which retail interest rates adjust sluggishly to changes in policy rates and the pass -through is potentially incomplete. In particular, we introduce costly financial intermediation, which gives rise ...