Working Paper: CEPR ID: DP5094
Authors: Andreas Schabert
Abstract: In this paper, we analyze the relation between interest rate targets and money supply in a (bubble-free) rational expectation equilibrium of a standard cash-in-advance model. We examine contingent monetary injections aimed to implement interest rate sequences that satisfy interest rate target rules. An interest rate target with a positive inflation feedback in general corresponds to money growth rates rising with inflation. When prices are not completely flexible, this implies that a non-destabilizing money supply cannot implement a forward-looking and active interest rate rule. This principle also applies for an alternative model version with an interest elastic money demand. The implementation of a Taylor rule then requires a money supply that leads to explosive or oscillatory equilibrium sequences. In contrast, an inertial interest rate target can be implemented by a non-destabilizing money supply, even if the inflation feedback exceeds one, which is often found in interest rate rule regressions.
Keywords: contingent money supply; interest rate inertia; interest rate rules; macroeconomic stability; policy equivalence
JEL Codes: E32; E41; E52
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| money supply (E51) | interest rate targets (E43) |
| interest rate targets (E43) | money supply (E51) |
| inflation (E31) | money supply (E51) |
| money supply (E51) | economic stability (E63) |
| interest rate targets (E43) | economic stability (E63) |
| inflation feedback (E31) | money growth rates (O42) |
| Taylor rule (E43) | money supply (E51) |
| inertial interest rate target (E43) | non-destabilizing money supply (E59) |
| output feedback (C67) | economic equilibria (D59) |