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Title: Money Supply and the Implementation of Interest Rate Targets

Author(s): Andreas Schabert

Publication Date: June 2005

Keyword(s): contingent money supply, interest rate inertia, interest rate rules, macroeconomic stability and policy equivalence

Programme Area(s): International Macroeconomics

Abstract: In this paper, we analyze the relation between interest rate targets and money supply in a (bubble-free) rational expectation equilibrium of a standard cash-in-advance model. We examine contingent monetary injections aimed to implement interest rate sequences that satisfy interest rate target rules. An interest rate target with a positive inflation feedback in general corresponds to money growth rates rising with inflation. When prices are not completely flexible, this implies that a non-destabilizing money supply cannot implement a forward-looking and active interest rate rule. This principle also applies for an alternative model version with an interest elastic money demand. The implementation of a Taylor rule then requires a money supply that leads to explosive or oscillatory equilibrium sequences. In contrast, an inertial interest rate target can be implemented by a non-destabilizing money supply, even if the inflation feedback exceeds one, which is often found in interest rate rule regressions.

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Bibliographic Reference

Schabert, A. 2005. 'Money Supply and the Implementation of Interest Rate Targets'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=5094