Article | Federal Reserve Bank of Richmond Economic Quarterly | 1996

Limits on Interest Rate Rules in the IS Model

by William R. Kerr and Robert G. King

Abstract

There has been a substantial amount of research on interest rate rules. This literature finds that the feasibility and desirability of interest rate rules depends on the structure of the model used to approximate macroeconomic reality. We employ a series of macroeconomic models to shed light on how aspects of model structure influence the limits on interest rate rules. In particular, we show that a simple respecification of the IS schedule, which we call the expectational IS schedule, makes the textbook model generate the same limits on interest rate rules as the fully articulated models. We then use this simple model to study the design of interest rate rules with nominal anchors. If the monetary authority adjusts the interest rate in response to deviations of the price level from a target path, then there is a unique equilibrium under a wide range of parameter choices: all that is required is that the authority raise the nominal rate when the price level is above the target path and lower it when the price level is below the target path. By contrast, if the monetary authority responds to deviations of the inflation rate from a target path, then a much more aggressive pattern is needed: the monetary authority must make the nominal rate rise by more than one-for-one with the inflation rate. Our results on interest rate rules with nominal anchors are preserved when we further extend the model to include the influence of expectations on aggregate supply.

Keywords: Inflation and Deflation; Macroeconomics; Interest Rates; Price; Governing Rules, Regulations, and Reforms; Performance Expectations;

Citation:

Kerr, William R., and Robert G. King. "Limits on Interest Rate Rules in the IS Model." Federal Reserve Bank of Richmond Economic Quarterly 82, no. 2 (1996): 47–75.