Working Paper: CEPR ID: DP5896
Authors: Mewael F. Tesfaselassie; Eric Schaling; Sylvester C.W. Eijffinger
Abstract: In this paper we incorporate the term structure of interest rates in a standard inflation forecast targeting framework. We find that under flexible inflation targeting and uncertainty in the degree of persistence in the economy, allowing for active learning possibilities has effects on the optimal interest rate rule followed by the central bank. For a wide range of possible initial beliefs about the unknown parameter, the dynamically optimal rule is in general more activist, in the sense of responding aggressively to the state of the economy, than the myopic rule for small to moderate deviations of the state variable from its target. On the other hand, for large deviations, the optimal policy is less activist than the myopic and the certainty equivalence policies.
Keywords: Learning; Rational Expectations; Separation Principle; Term Structure of Interest Rates
JEL Codes: C53; E43; E52; F33
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| central bank's learning about the economy (E58) | central bank's optimal interest rate rule (E52) |
| central bank's optimal interest rate rule (E52) | policy response to small to moderate deviations (E63) |
| policy response to large deviations (H12) | central bank's optimal policy becomes less activist (E63) |
| central bank's learning about the unknown persistence parameter (E19) | policy decisions (D78) |