Working Paper: NBER ID: w8684
Authors: Carlos A. Vegh
Abstract: Policymakers increasingly view short-term nominal interest rates as the main instrument of monetary policy, often in conjunction with some inflation target. Interest rates on short-term indexed government debt (i.e., a real interest rate) have also been used as policy instruments. To understand the pros and cons of different policy rules and instruments, this paper derives some basic equivalences among different policy rules. It is shown that, under certain conditions, the following three rules are exactly equivalent: (i) a 'k-percent' money growth rule; (ii) a nominal interest rate rule combined with an inflation target; and (iii) a real interest rate rule combined with an inflation target. These policy rules, however, become increasingly complex: the first rule requires no feedback mechanism; the second rule requires responding to the inflation gap; while the third rule involves responding to both the inflation gap and the output gap. It is also shown that policy rules which respond to the output gap may avoid a deflationary adjustment.
Keywords: Monetary Policy; Interest Rates; Inflation Targeting
JEL Codes: E52; E58
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| k-percent money growth rule (O42) | inflation control (E64) |
| nominal interest rate rule + inflation target (E43) | inflation control (E64) |
| real interest rate rule + inflation target (E43) | inflation control (E64) |
| policy rules responding to output gap (E61) | avoid deflationary adjustments (E31) |
| output gap response (E23) | inflation outcomes (E31) |
| more responsive monetary policies (E63) | mitigate risks associated with deflation (E31) |