The value of interest rate stabilization polices when agents are learning

We examine the expectational stability (E—stability) of rational expectations equilibrium in the standard, “New Keynesian” model of the monetary transmission mechanism when monetary policy is optimally derived. We suppose that the monetary authority adds interest rate stabilization to its other two objectives of inflation and output stabilization, and we consider the optimal interest rate rule derived under regimes of discretion or commitment. We show that under either regime, the optimal policy rule yields rational expectations equilibria that are E-stable for a wide range of empirically plausible parameter values. This finding stands in contrast to the findings of Evans and Honkapohja (2002, 2003ab) for optimal monetary policy rules in environments where interest rate stabilization is not part of the central bank’s objective function.