On the Limits of Monetary Policy

Abstract

This paper provides theory and evidence that distorted long-term interest-rate expectations represent a fundamental constraint on monetary policy design. Permitting beliefs to depart from those consistent with rational expectations equilibrium breaks the tight link between policy rates and long-term expectations, even when long-term interest rates are determined by the expectations hypothesis of the yield curve. Because bond prices are excessively sensitive to short-term interest rates, the central bank faces an intertemporal trade-off which results in optimal policy being less aggressive relative to rational expectations. More aggressive policy leads to sub-optimal volatility in long-term interest rates and aggregate demand through standard intertemporal substitution effects. These effects are quantitatively important over the Great Inflation and Great Moderation periods of US monetary history.

About the presenter’s visit

Professor Bruce Preston will be visiting the School of Economics on Wednesday 10^th April 2019. While here he will be using room 520A Colin Clark Building. If you would like to meet with him or have lunch or dinner with him please contact Dr Jorge Miranda Pinto who will be his host while at The University of Queensland. Dr Miranda Pinto can be contacted on j.mirandapinto@uq.edu.au.