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I consider the desirability of the observed tendency of central banks to adjust interest rates only gradually in response to changes in economic conditions. I show, in the context of a simple model of optimizing private sector behaviour, that such inertial behaviour on the part of the central bank may indeed be optimal, in the sense of minimizing a loss function that penalizes inflation variations, deviations of output from potential and interest rate variability. Sluggish adjustment characterizes an optimal policy commitment, even though no such inertia would be present in the case of discretionary optimization.

This paper considers the desirability of the observed tendency of central banks to adjust interest rates only gradually in response to changes in economic conditions. It shows, in the context of a simple model of optimizing private-sector behavior, that such inertial behavior on the part of the central bank may indeed be optimal, in the sense of minimizing a loss function that penalizes inflation variations, deviations of output from potential, and interest-rate variability. Sluggish adjustment characterizes an optimal policy commitment, even though no such inertia would be present in the case of a reputationless (Markovian) equilibrium under discretion. Optimal interest-rate feedback rules are also characterized, and shown to involve substantial positive coefficients on lagged interest rates. This provides a theoretical explanation for the numerical results obtained by Rotemberg and Woodford (1998) in their quantitative model of the U.S. economy.

This paper considers the desirability of the observed tendency of central banks to adjust interest rates only gradually in response to changes in economic conditions. It shows, in the context of a simple model of optimizing private-sector behavior, that such inertial behavior on the part of the central bank may indeed be optimal, in the sense of minimizing a loss function that penalizes inflation variations, deviations of output from potential, and interest-rate variability. Sluggish adjustment characterizes an optimal policy commitment, even though no such inertia would be present in the case of a reputationless (Markovian) equilibrium under discretion. Optimal interest-rate feedback rules are also characterized, and shown to involve substantial positive coefficients on lagged interest rates. This provides a theoretical explanation for the numerical results obtained by Rotemberg and Woodford (1998) in their quantitative model of the U.S. economy.

PurposeThe purpose of this paper is to examine the inertia of monetary policy in the Jordanian economy, in which the monetary policy is neutral owing to the adoption of a fixed exchange rate with the US dollar. The question of the current paper is: Does monetary policy inertia exist in such an economy despite the fact that the exchange rate is pegged to a foreign currency?Design/methodology/approachTo test the hypothesis of the current paper in Jordan, the Taylor rule, adjusted to be consistent with the context of monetary policy in Jordan, is estimated. Moreover, the model is estimated by two techniques: OLS and the Kalman filter, using quarterly data over the period (1994:1‐2007:1).FindingsThe empirical evidence from the Jordanian economy shows that monetary policy inertia is highly significant in Jordan. The coefficient of the lagged interest rate is estimated to lie between 0.60 and 0.69. Moreover, the evidence illustrates that both inflation rate and output gap have an insignificant effect on setting the policy rate. Further, the policy interest rate seems to be set gradually in reaction to monetary policy inertia, unobserved variable and foreign interest rate.Originality/valueThe paper investigates monetary policy inertia in a developing country whose economy is small, widely open and has a fixed exchange rate with the US dollar.

ABSTRACTIntroducing in a central bank loss function asymmetric preferences for interest rate stabilization together with a (symmetric) smoothing goal could lead to asymmetric interest rate smoothing. An empirical analysis supports this theoretical result and finds for the disinflation (Volcker) period a more cautious adjustment of interest rates downwards than upwards, and for the 'price stability' (Greenspan) period a more inertial behaviour in the opposite direction.