Working Papers

2019-03 | January 2019

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Optimal Monetary Policy Regime Switches

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An economy that switches between high and low growth regimes creates incentives for the monetary authority to change its rule. As lower growth tends to produce lower real interest rates, the monetary authority has an incentive to increase the inflation target and increase the degree of inertia in setting rates in an attempt to keep the nominal rate positive. An optimizing monetary authority therefore responds to permanently lower growth by slightly increasing both the inflation target and inertia; focusing solely on the inflation target ignores a key margin of adjustment. With repeated growth rate regime switches, an optimal monetary rule that switches at the same time internalizes both the direct effects of growth regime change and the indirect expectation effects generated by switching in policy. The switching rule improves economic outcomes relative to a constant rule and one that does not consider the impact of regime changes; this result is robust to the case when the monetary authority misidentifies the growth regime with relatively high frequency.

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Article Citation

Choi, Jason, and Andrew Foerster. 2019. "Optimal Monetary Policy Regime Switches," Federal Reserve Bank of San Francisco Working Paper 2019-03. Available at https://doi.org/10.24148/wp2019-03