Working Paper: CEPR ID: DP6570
Authors: John Driffill; Zeno Rotondi
Abstract: The inertia found in econometric estimates of interest rate rules is a continuing puzzle. Many reasons for it have been offered, though unsatisfactorily, and the issue remains open. In the empirical literature on interest rate rules, inertia in setting interest rates is typically modelled by specifying a Taylor rule with the lagged policy rate on the right hand side. We argue that inertia in the policy rule may simply reflect the inertia in the economy itself, since optimal rules typically inherit the inertia present in the model of the economy. Our hypothesis receives some support from US data. Hence we agree with Rudebusch (2002) that monetary inertia is, at least partly, an illusion, but for different reasons.
Keywords: Expectations; Hypothesis; Interest Rate Rules; Interest Rate Smoothing; Monetary Policy; Monetary Policy Inertia; Predictability of Interest Rates; Taylor Rule; Term Structure
JEL Codes: E52; E58
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| lagged output gap (E23) | current interest rate (E43) |
| lagged inflation (E31) | current interest rate (E43) |
| inertia in output gap and inflation (E31) | predictability of interest rates (E43) |