1

Economic Modelling

Lecture 16

Interest Rate Rule and Central Bank Independence

2

Interest Determination Rule

• Higher interest in the past period lowers the level of output at the current perio

• Higher output at the current period raises the rate of inflation (remember the aggregate supply

• Interest should be raised when the economy is overheating: output is above the trend to reduce the inflationary pressure

• It should be raised also when the rate of inflation is above the target inflation to reduce aggregate demand

• Interest rate should be lowered in recession• Interest rates should be determined based on economic

facts but not according to whims of the policy makers• An independent central can take such an independent

decision

3

*11

*ti

tidtyty 0d (9)

where ty is actual output *ty is trend output, ti is the actual

interest rate and *ti the basic interest rate,

One period lag is assumed between the interest rate decision and the change in the output.

*11

*ty

tyctt 0c (10)

where t and *t are actual and target inflation rates.

Interest rate rule:

***ttbtytyatiti 0a ; 0b (11)

Interest Determination Rule to Achieve the Inflation Target: Taylor Rule

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Reduced Form Equation of the Interest Determination Model

*11

*ti

tidtyty

*11

*ty

tyctt

***ttbtytyatiti 0a ; 0b

(11)

Substituting the output and inflation equations in the interest

rate rule:

*

22*

11*

ti

ticdb

ti

tidatiti

*22

*11

*titibcdtitiadtiti

*2

*1

*21 tbcditadititbcditaditi (12)

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Why Should the Central Bank Be Independent?Inflation Biases of a Government and a Central

Bank Figure 1

G

Preference of government and a conservative central bank regarding inflation and output AS Preference of Government (GP)Inflation A

AS1

B Preference of a CB (CP)

O Yn Output

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Lessons for Price Stability From Analysis of the Central Bank Independence

1. Bind the central bank with a zero inflation rate target.

2. Appoint the most conservative central banker.

3. Make the central bank as independent as possible fromthe government.

4. Peg the exchange rate to the currency of a country withone or more of the above characteristics.

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Inflationary Bias Model-Loss Functions of a Government and a CB and Supply

ConstraintG o v e r n m e n t s o b j e c t i v e f u n c t i o n :

t

Min

2*

22

21

tytybt

GL ( 1 )

C e n t r a l b a n k s ’ o b j e c t i v e f u n c t i o n :

t

Min

2*

22

21

tytybt

CBL ( 2 )

A g g r e g a t e s u p p l y C o n s t r a i n t s :

tuettty

( 3 )

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Inflation Bias of the Government

2*

22

21

tytu

ett

bt

GL

0*

tytuettbt

t

GL

tubb

tybb

t

1*

1

9

Inflation Bias of the Central Bank

2*

22

21

tytu

ett

bt

CBL

*1 tytu

ettbt

t

CBL

tubb

tybb

t

1*

1

H ere is the in fla tion aversion fac to r. S ince 0 thecen tra l bank w ou ld choose low er ra te o f in fla tion thanthe governm en t.

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Inflation Bias When the Central Bank is under the Spell or when it is Completely Independent

2*

22

211

2*

22

21

tytuett

bttytue

ttb

ttM

2*

21

22

21

21

tytuett

bbttM

2*

22

21

tytuett

bttM

0*1

tytuettbt

ttM

tub

bty

bb

t

1*

1

11

References• Alesina A, L. H. Summers (1993) Central Bank Independence and

Macroeconomic Performance: Some Comparative Evidence Journal of Money, Credit and Banking, 25: 2: 151-162, May.

• Bernanke B. S. and F.S. Mishkin (1997) Inflation Targeting: A New Fremework for Monetary Policy, Journal of Economic Perspectives, vol. II, no.2, Spring, pp. 97-116.

• Bhattarai (2002) An Analysis of Interest Determination in the UK and Four Major Leading Economies, Research Memorandum no. University of Hull.

• Goodhart Charles (1989) The Conduct of Monetary Policy, Economic Journal, 99, June, pp. 293-346.

• Hicks, J. R. (1937) Mr. Keynes and the “Classics”; A Suggested Interpretations, Econometrica 5:1:147-159.

• Friedman, M. (1968), "The Role of Monetary Policy," American Economic Review, No.1 vol. LVIII March

• Monetary Policy Committee, Bank of England Transmission Mechanism of Monetary Policy.

• Taylor J (1993) Discretion versus policy rules in practice, Carnegie Rochester Conference Series on Public Policy 29 Amsterdam.