Interest Rate Feedback Rules in an Open Economy with Forward Looking Inflation
| Published date | 01 May 2001 |
| Date | 01 May 2001 |
| DOI | http://doi.org/10.1111/1468-0084.00217 |
| Author | Campbell Leith,Simon Wren‐Lewis |
Interest rate feedback rules in an open
economy with forward looking inflationy
Campbell Leith and Simon Wren-Lewis
University of Glasgow
University of Exeter
I. Introduction
With the adoption of an explicit in¯ation target in the UK, there has been
renewed interest in the properties of alternative feedback rules for interest
rates based on an in¯ation target. Following Svensson (1999) there is also a
growing literature which argues that welfare may be improved by targeting
the price level rather than in¯ation as a credible price level target can provide
a strong nominal anchor for expectations.
In this paper we address both these issues by comparing the stabilization
properties of the two forms of feedback rule that have been used most
frequently in the literature and in policy discussion. Speci®cally, we examine
the relative merits of relating excess in¯ation to the level of interest rates, or
the change in interest rates. Relating the change in interest rates to excess
in¯ation implies price level control, so our results are directly relevant to the
discussion of price level versus in¯ation control in the recent literature.
However, the model in which we embed our two policy rules is richer than
that considered in the price level targeting literature, in that we allow for lags
in the monetary transmission mechanism, signi®cant inertia in in¯ation and
exchange rate effects. This allows us to differentiate between different kinds
of shocks in a setting which would be more recognisable to policy makers.
Section II of the paper outlines the two rules, and draws some general
conclusions about their properties that are model independent. Section III
outlines a theoretical open economy model, which extends the range of
features typically found in the models employed in the literature on price
OXFORD BULLETIN OF ECONOMICS AND STATISTICS, 63, 2 (2001) 0305-9049
#Blackwell Publishers Ltd, 2001. Published byBlackwell Publishers, 108 Cowley Road, Oxford OX4 1JF, UKand 350
Main Street, Malden, MA 02148, USA.
209
yWe would like to express our thanks to David Vines for very helpful comments. Financial
assistance under ESRC grant No. L116251026 is also gratefully acknowledged.
level versus in¯ation targeting. This section also considers whether price
level control is a necessary condition of price level determinacy. In Section
IV we parameterize the model and consider the importance of de®ning excess
in¯ation in terms of output or consumer prices1and how the type of shocks
hitting the economy can affect the performance of simple interest rate
feedback rules. Section V concludes.
II. Alternative Feedback Rules
In this paper we consider two types of feedback rule. The ®rst is of the form,
RtRtÿ1a(ðtÿð) (1)
where Ris the nominal interest rate, ðis the rate of in¯ation and ðis the
in¯ation target. In this rule, if in¯ation is above target then the government
keeps raising interest rates until the rate of in¯ation is no longer above target.
This form of rule has been analysed extensively in Blake and Westaway
(1994 and 1996) and has been used in most of the macroeconometric models
of the U.K. economy (Church et al., 1995).
The rule has the property that, for a given target, any shock to the price
level is completely reversed. Suppose we start from equilibrium in period 0,
and then some shock occurs. By cumulating (1), the level of interest rates in
period Nis given by,
RNR0aX
N
t0
(ðtÿð) (2)
assuming an unchanged in¯ation target. That is, the level of the deviation of
the interest rate from base is proportional to the sum of the deviations of
in¯ation from target. In an open economy subject to an uncovered interest
rate parity condition, interest rates must eventually return to base. This
implies that the sum of deviations of in¯ation from its target must be zero,
which in turn implies that once equilibrium is restored the price level returns
to the level it would have taken if no shock had occurred. Thus, following a
positive shock to in¯ation, interest rates will climb until in¯ation returns to
its target level, but then in¯ation must fall below target to get interest rates
back down again. We therefore describe this rule as the price level targeting
rule.
The price level targeting rule also implies that in¯ation will overshoot if
the in¯ation target is changed. A reduction in the in¯ation target of, say,
1For a discussion of how the distinction between output and consumer prices affects monetary
growth targeting, see Vines et al. (1983, pp. 29± 30).
210 Bulletin
#Blackwell Publishers 2001
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