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“WAIT-AND-SEE” MONETARY POLICY

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

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.

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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: xiaowen_lei@sfu.ca.
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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.

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Macroeconomic Dynamics
  • ISSN: 1365-1005
  • EISSN: 1469-8056
  • URL: /core/journals/macroeconomic-dynamics
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