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 positive. 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 and one that does not consider the impact of regime changes; this result is robust to the case when the monetary authority misidentifies the growth regime with relatively high frequency.

JEL Classification: C63; E31; E52;

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

Access Documents

File(s): File format is application/pdf https://www.frbsf.org/economic-research/publications/working-papers/2019/03/
Description: Full text

Authors

Bibliographic Information

Provider: Federal Reserve Bank of San Francisco

Part of Series: Working Paper Series

Publication Date: 2019-02-01

Number: 2019-3

Pages: 31 pages