Should Monetary Policy Use Long-Term Rates?

This paper studies two roles that long-term nominal interest rates can play in the conduct of monetary policy in a New Keynesian model. The first allows long-term rates to enter the reaction function of the monetary authority. The second considers the possibility of using long-term rates as instruments of policy. It is shown that in both cases a unique rational expectations equilibrium exists. Reacting to movements in long yields does not improve macroeconomic performance as measured by the loss function. However, long-term rates turn out to be better instruments when the relative concern of the monetary authority for inflation volatility is high. ∗I am indebted to Peter Ireland for his help and support. I also wish to thank, Pierluigi Balduzzi, Kit Baum, David Belsley, Fabio Ghironi, Chris Kent, Kristoffer Nimark, Glenn Rudebusch, Fabio Schiantarelli, Richard Tresch and participants at the Dissertation and Monetary Economics Seminars at Boston College for helpful comments. All errors are my own. †This paper is based on Chapter 2 of my doctoral dissertation, "Money, interest rates, and monetary policy", at Boston College. ‡Please address correspondence to: Mariano Kulish, Economic Research, Reserve Bank of Australia, GPO Box 3947, Sydney, 2001, NSW, Australia, T: (61) 2 9551 8841 E: [email protected]