Skip to content
Licensed Unlicensed Requires Authentication Published by De Gruyter October 18, 2010

Policy Irreversibility and Interest Rate Smoothing

  • Teruyoshi Kobayashi

Many empirical studies argue that the inertial behavior of policy rates in industrialized countries can be well explained by a linear partial adjustment version of the Taylor rule. However, the explanatory power of the lagged interest rate has been questioned from various points of view. This paper formally examines a situation in which a central bank has an aversion to frequent policy reversals. Imposing an irreversibility constraint on the control space makes the lagged interest rate a state variable. However, the policy function cannot then be expressed as a partial adjustment form, even if the original Taylor rule would be the correct policy function in the absence of the irreversibility constraint. The simulation results reveal that conventional regression tends to falsely support the functionally misspecified partial adjustment model. This implies that the significant role of the lagged interest may simply reflect the central banks’ aversion to policy reversal.

Published Online: 2010-10-18

©2011 Walter de Gruyter GmbH & Co. KG, Berlin/Boston

Downloaded on 22.3.2023 from
Scroll Up Arrow