A Financial Approach to Optimal Interest Rate Rules: Multiple Objectives and Asymmetries
24 Pages Posted: 29 Mar 2010
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
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