DP4135 The Learning Cost of Interest Rate Reversals

Author(s): Martin Ellison
Publication Date: December 2003
Keyword(s): interest rate smoothing, learning, monetary policy
JEL(s): D83, E52, E58
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=4135

In this Paper, we suggest a new motivation for why central banks appear averse to reversing recent changes in their interest rate. We show, in a standard monetary model with forward-looking expectations, data uncertainty and parameter uncertainty, that there is a learning cost associated with interest rate reversals. A policy that frequently reverses the interest rate makes it more difficult for the central bank and private agents to learn the key parameters of the model. Optimal monetary policy internalizes this learning cost and therefore has a lower number of interest rate reversals. The incentive to reduce the number of interest rate reversals is in addition to the optimal policy inertia created by the presence of forward-looking expectations and uncertainty in the model.