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Federal Reserve Bank of San Francisco
Working Paper Series
Optimal Monetary Policy Regime Switches
Jason Choi
Andrew Foerster
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.


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Jason Choi & Andrew Foerster, Optimal Monetary Policy Regime Switches, Federal Reserve Bank of San Francisco, Working Paper Series 2019-3, 01 Feb 2019.
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DOI: 10.24148/wp2019-03
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