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 Interest Determination Rule to Achieve the Inflation Target: Taylor Rule

4 Reduced Form Equation of the Interest Determination Model

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

6 Lessons for Price Stability From Analysis of the Central Bank Independence

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

8 Inflation Bias of the Government

9 Inflation Bias of the Central Bank

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

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: , 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 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 Hicks, J. R. (1937) Mr. Keynes and the Classics; A Suggested Interpretations, Econometrica 5:1: 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.