interest rate and monetary policy

Topics: Inflation, Central bank, Macroeconomics Pages: 9 (4919 words) Published: November 2, 2014
Applied Economics, 2009, 41, 2005–2012

Interest rates and monetary policy
S. Gazioglua and W. D. McCauslandb,*

Department of Economics and Institute of Applied Mathematics, Middle East Technical University (METU), Ankara, Turkey
Department of Economics, University of Aberdeen, Edward Wright Building, Old Aberdeen, AB24 3QY, UK

This article conducts a thorough intertemporal analysis of nominal interest rate based monetary policy. Its main contribution is to show how such a policy can have different effects depending on the assumptions made about the saving and borrowing behaviour of firms. We consider two cases: (i) consumers are savers and firms are borrowers and (ii) both consumers and firms are borrowers (the nation as a whole is borrowing from abroad). In one case we confirm conventional wisdom, but in the other case we find there may be unexpected and surprising results. Moreover, our analysis has important implications for both inflation and nominal exchange rate targeting policies.

I. Introduction
The central innovation of this article is that it
conducts a thorough intertemporal analysis of the
effects of using the nominal interest rate as the
instrument of monetary policy. It pays careful
attention to the impact of different assumptions
about the saving and borrowing behaviour of
consumers and firms in generating different policy
effects and the role of inflation in accounting for the
divergence between the real interest rate and the real
return on capital.
The debate concerning choice of monetary policy
instrument can be traced right back to Poole (1970)
who analysed the choice between the nominal
interest rate and the nominal money stock in the
presence of stochastic shocks. In the absence of
risk, the choice of the nominal interest merely
implies a willingness to allow the money stock to
adjust endogenously to accommodate the nominal
interest rate target. Sargent and Wallace (1975)
then showed that, under rational expectations,

nominal interest rate pegging led to an indeterminate price level. It was later shown that minor re-specifications of the model could restore price
determinacy, such as specifying the aggregate
demand function in terms of the real money
stock, as in McCallum (1981). It is implicitly this
specification that is embodied in our model, hence
ensuring price determinacy. Artis and Currie (1981)
then extended this conventional ISLM-based
analysis to explicitly consider the effects of
exchange rate targeting. In the late 1980s the
emphasis of research shifted to the analysis of
target zones, reflecting in part the problems
experienced by national monetary authorities operating under the European Exchange Rate Mechanism and in part the development of the
application of techniques of stochastic calculus.
This literature used stochastic extensions of either
simple monetary or Dornbusch (1976) models to
focus on the analysis of regime switches and the
effects of speculative attacks. A good representative
collection of this literature is to be found in

*Corresponding author. E-mail:
Applied Economics ISSN 0003–6846 print/ISSN 1466–4283 online ß 2009 Taylor & Francis
DOI: 10.1080/00036840601019372


S. Gazioglu and W. D. McCausland

Krugman and Miller (1992). Mishkin (1999)
and Taylor (1999) consider different monetary
Since the nominal interest rate has increasingly
become the central instrument of monetary policy
in recent years, it is necessary for economists once
again to turn their attention to renewing the
analysis of this monetary policy but under a
Turnovsky (1986) and Turnovsky and Grinols
(1996) show how optimal monetary policy should
be directed towards interest rate targeting, modelling the intertemporal utility of representative agents. In their article they show that reasonable
monetary growth...

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