Working Paper

Optimal Monetary Policy Regime Switches

Abstract: An economy that switches between high and low growth regimes creates incentives for the monetary authority to change its rule. As lower growth tends to produce lower real interest rates, the monetary authority has an incentive to increase the inflation target and increase the degree of inertia in setting rates in an attempt to keep the nominal rate away from the zero lower bound. An optimizing monetary authority therefore responds to permanently lower growth by slightly increasing both the inflation target and inertia; focusing solely on the inflation target ignores a key margin of adjustment. With repeated growth rate regime switches, an optimal monetary rule that switches at the same time internalizes both the direct effects of growth regime change and the indirect expectation effects generated by switching in policy. The switching rule improves economic outcomes relative to a constant rule. A constant rule may be preferred if the monetary authority attempts a switching rule but implements the wrong rule with high enough frequency.

Keywords: Growth rate; optimal policy; regime switching; Taylor rule; inflation target; zero lower bound;

JEL Classification: C63; E31; E52;

https://doi.org/10.24148/wp2019-03

Bibliographic Information

Provider: Federal Reserve Bank of San Francisco

Part of Series: Working Paper Series

Publication Date: 2020-09-09

Number: 2019-3

Note: The first version of this paper was February 1, 2019.