A Financial Approach to Optimal Interest Rate Rules: Multiple Objectives and Asymmetries

24 Pages Posted: 29 Mar 2010

See all articles by Katarzyna Romaniuk

Katarzyna Romaniuk

Université de Paris 1 Panthéon-Sorbonne; Xi'an Jiaotong-Liverpool University (XJTLU)

Radu Vranceanu

ESSEC Business School; University of Cergy-Pontoise - THEMA

Date Written: March 24, 2010


The dominant approach to monetary policy builds on simple linear policy rules, assumed to describe the systematic response of central banks to various shocks. The last financial crisis has shown that in difficult times central banks follow more sophisticated strategies. We argue in this paper that such responses can be defined as optimal responses of the policymaker and not as deviations from a simple linear rule. For so doing, we propose an alternative approach inspired by the financial management literature. The central bank is represented as a portfolio manager that gears the policy instrument in order to achieve multiple policy goals in a stochastic continuous-time setting. Possible asymmetries in the reaction function are considered, translated in the form of calls and puts. The optimization program solution is interpreted in the light of the principles governing the portfolio manager optimal behavior. A novel result is also provided as to the necessity to incorporate the stock price stabilization term in the central bank decision rule.

Keywords: optimal interest rate rule, portfolio choice, stochastic dynamic programming, asset prices, options theory

JEL Classification: E58, G11, C61

Suggested Citation

Romaniuk, Katarzyna and Vranceanu, Radu, A Financial Approach to Optimal Interest Rate Rules: Multiple Objectives and Asymmetries (March 24, 2010). Available at SSRN: https://ssrn.com/abstract=1577854 or http://dx.doi.org/10.2139/ssrn.1577854

Katarzyna Romaniuk (Contact Author)

Université de Paris 1 Panthéon-Sorbonne ( email )

17, rue de la Sorbonne
Paris, 75005

Xi'an Jiaotong-Liverpool University (XJTLU) ( email )

111 Renai Road, SIP
Suzhou, JiangSu province 215123

Radu Vranceanu

ESSEC Business School ( email )

3, Av. Bernard Hirsch
PB 50105
Cergy-Pontoise, 95021

HOME PAGE: http://www.essec.fr

University of Cergy-Pontoise - THEMA ( email )

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F-95011 Cergy-Pontoise Cedex, 95011

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