Skip to main content


  • Xiaowen Lei (a1) and Michael C. Tseng (a2)

This paper develops a model of the optimal timing of interest rate changes. With fixed adjustment costs and ongoing uncertainty, changing the interest rate involves the exercise of an option. Optimal policy therefore has a “wait-and-see” component, which can be quantified using option pricing techniques. We show that increased uncertainty makes the central bank more reluctant to change its target interest rate, and argue that this helps explain recent observed deviations from the Taylor Rule. An optimal wait-and-see policy fits the target interest rates of the Fed and Bank of Canada better than the Taylor Rule.

Corresponding author
Address correspondence to: Xiaowen Lei, Department of Economics, Simon Fraser University, WMC 2700, 8888 University Dr, Burnaby, BC, V5A 1S6, Canada; e-mail:
Hide All

We gratefully acknowledge Kenneth Kasa, without whose guidance, patience, and encouragement this paper would not have been possible. We are also especially grateful to an anonymous referee for many useful suggestions. We also thank Galo Nuño, James Costain, Janet Hua Jiang, Jinill Kim, Edouard Djeutem, David Andolfatto, Robert Jones, Luba Petersen, John Knowles, Lucas Herrenbrueck, Peter Zadrozny, and participants in the Simon Fraser University Economics PhD seminar, and Simon Fraser University Economics Brown Bag seminar, for helpful comments. We are responsible for all the remaining errors.

Hide All
Adams, Robert A. and Fournier, John J. F. (2003) Sobolev Spaces. Amsterdam: Academic Press.
Alba, Joseph D. and Wang, Peiming (2017) Taylor Rule and discretionary regimes in the United States: Evidence from a k-state Markov regime-switching model. Macroeconomic Dynamics 21, 817833.
Alvarez, Fernando and Dixit, Avinash (2014) A real options perspective on the future of the Euro. Journal of Monetary Economics 61, 78109.
Barndorff-Nielsen, E. Ole, Mikosch, Thomas, and Resnick, Sidney I. (2001) Lévy Processes: Theory and Applications. New York: Springer.
Blinder, Alan S. (2009) Making monetary policy by committee. International Finance 12, 171194.
Bloom, Nicholas, Floetotto, Max, Jaimovich, Nir, Saporta-Eksten, Itay, and Terry, Stephen J. (2012) Really Uncertain Business Cycles. Technical report no. w18425, National Bureau of Economic Research.
Caplin, Andrew and Leahy, John (1994) Business as usual, market crashes, and wisdom after the fact. American Economic Review 84, 548565.
Davig, Troy and Leeper, Eric M. (2008) Endogenous monetary policy regime change. In Reichlin, Lucrezia and West, Kenneth (eds.), NBER International Seminar on Macroeconomics 2006, pp. 345391. Chicago: University of Chicago Press.
Dixit, Avinash K. (1993) The Art of Smooth Pasting. Switzerland: Harwood Academic Publishers.
Dixit, Avinash K. (1994) Investment Under Uncertainty. Princeton, NJ: Princeton University Press.
Dynkin, Evgeniĭ B. (1965) Markov Processes. New York: Springer.
Fernández-Villaverde, Jesús, Posch, Olaf, and Rubio-Ramírez, J. F. (2012) Solving the new Keynesian model in continuous time. Unpublished manuscript, Federal Reserve Bank of Atlanta.
Froot, Kenneth A. and Obstfeld, Maurice (1989) Stochastic Process Switching: Some Simple Solutions. Technical report no. w2998, National Bureau of Economic Research.
Galí, Jordi (2009) Monetary Policy, Inflation, and the Business Cycle: An Introduction to the New Keynesian Framework. Princeton, NJ: Princeton University Press.
Galí, Jordi and Gertler, Mark (1999) Inflation dynamics: A structural econometric analysis. Journal of Monetary Economics 4, 195222.
Gel'fand, Izrail M. and Vilenkin, N. Ya. (2014) Generalized Functions: Applications of Harmonic Analysis. New York: Academic Press.
Holston, Kathryn, Laubach, Thomas, and Williams, John (2017) Measuring the natural rate of interest: International trends and determinants. Journal of International Economics. doi:10.1016/j.jinteco.2017.01.004.
Kahn, George A. (2010) Taylor rule deviations and financial imbalances. Federal Reserve Bank of Kansas City, Economic Review 95 (2), 6399.
Levin, Andrew T. and Williams, John C. (2003) Robust monetary policy with competing reference models. Journal of Monetary Economics 50, 945975.
Levin, Andrew T., Wieland, Volker, and Williams, John C. (1999) Robustness of simple monetary policy rules under model uncertainty. In Taylor, John B. (ed.), Monetary Policy Rules, pp. 263318. Chicago: University of Chicago Press.
Lipster, Robert S. and Shiryayev, Albert N. (1989) Theory of Martingales. Pordrecht, The Netherlands: Kluwer.
Littman, Walter, Stampacchia, Guido, and Weinberger, Hans F. (1963) Regular points for elliptic equations with discontinuous coefficients. Annali della Scuola Normale Superiore di Pisa-Classe di Scienze 17, 4377.
Mankiw, N. Gregory and Reis, Ricardo (2002) Sticky information versus sticky prices: A proposal to replace the New Keynesian Phillips curve. The Quarterly Journal of Economics 117, 12951328.
Miao, Jianjun and Wang, Neng (2011) Risk, uncertainty, and option exercise. Journal of Economic Dynamics and Control 35, 442461.
Murray, Christian J., Nikolsko-Rzhevskyy, Alex, and Papell, David H. (2015) Markov switching and the Taylor principle. Macroeconomic Dynamics 19, 913930.
Øksendal, Bernt (1985) Stochastic processes, infinitesimal generators and function theory. Operators and Function Theory 153, 139162.
Protter, Philip E. (2004) Stochastic Integration and Differential Equations. Berlin: Springer.
Rotemberg, Julio J. and Woodford, Michael (1999) Interest rate rules in an estimated sticky price model. In Taylor, John B. (ed.), Monetary Policy Rules, pp. 57126. Chicago: University of Chicago Press.
Rudebusch, Glenn D. (2006) Monetary policy inertia: Fact or fiction? International Journal of Central Banking 2, 85135.
Sargent, Thomas J. (1999) The Conquest of American Inflation. Princeton, NJ: Princeton University Press.
Sims, Christopher A. (2010) Rational inattention and monetary economics. In Friedman, Benjamin M. and Woodford, Michael (eds.), Handbook of Monetary Economics, 1st ed., vol. 3, pp. 155181. Amsterdam: North Holland.
Stokey, Nancy L. (2008) The Economics of Inaction: Stochastic Control Models with Fixed Costs. Princeton, NJ: Princeton University Press.
Stokey, Nancy L. (2016) Wait-and-see: Investment options under policy uncertainty. Review of Economic Dynamics 21, 246265.
Svensson, Lars E. O. and Williams, Noah (2008) Optimal monetary policy under uncertainty: A Markov jump-linear-quadratic approach. Federal Reserve Bank of St. Louis Review 90, 275293.
Taylor, John B. (2014) The role of policy in the Great Recession and the weak recovery. American Economic Review 104, 6166.
Trojanowska, Magdalena and Kort, Peter M. (2010) The worst case for real options. Journal of Optimization Theory and Applications 146, 709734.
Woodford, Michael (1999) Optimal monetary policy inertia. The Manchester School 67, 135.
Woodford, Michael (2003) Interest and Prices: Foundations of A Theory of Monetary Policy. Princeton, NJ: Princeton University Press.
Recommend this journal

Email your librarian or administrator to recommend adding this journal to your organisation's collection.

Macroeconomic Dynamics
  • ISSN: 1365-1005
  • EISSN: 1469-8056
  • URL: /core/journals/macroeconomic-dynamics
Please enter your name
Please enter a valid email address
Who would you like to send this to? *