Ruhr Economic Papers

Ruhr Economic Papers #115

An Interest Rate Peg Might Be Better than You Think

by Markus Hörmann and Andreas Schabert

RGS Econ and TU Dortmund, 06/2009, 13 S./p., 8 Euro, ISBN 978-3-86788-128-9

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Abstract

Active interest rate policy is frequently recommended based on its merits in reducing macroeconomic volatility and being a simple and transparent policy device. In a standard New Keynesian model, we show that an even simpler policy, namely an interest rate peg, can be welfare enhancing: The minimum state variable solution and an autoregessive solution under a peg can lead to lower welfare losses than the unique solution under an active interest rate rule. Given that a peg is usually blamed to facilitate endogenous fluctuations, we further show that a peg can be implemented in a way that ensures equilibrium determinacy.

JEL-Classification: E52, E51, E32

Keywords: Interest rate rules; welfare losses; equilibrium determinacy; fundamental solutions

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