Optimal monetary policy and long-term interest rate dynamics: Taylor rule extensions

Many proposals are made to extend Taylor rule by including in the optimal reaction function other variables than those originally introduced by Taylor (Discretion versus policy rules in practice, Carnegie-Rochester Conference Series on Public Policy, 1993). The empirical studies point out the importance of long-term interest rates to explain and to forecast the behaviour of the monetary policy control variable. In particular, the positive shocks on long-term interest rates seem to induce a restrictive monetary policy and this finding is explained through the hypothesis that these shocks include the rational expectations on the future inflation rate. McCallum (Federal Reserve of Richmond Economic Quarterly, 91(4), 1–21, 2005) assumes a positive relation between long-term and short-term interest rates to explain the inconsistency of US data with the expectations theory of the interest rate term structure. In this paper a new theoretical model is developed and analysed where the model of Clarida et al. (Journal of Economic Literature, 37(4), 1661–1707, 1999) is extended in the above outline of the term structure rational expectations hypothesis and also the dynamics of the nominal long-term interest rate as well as the dynamics of real exchange rate are involved. The optimal reaction function is provided by the algorithm described in Dennis (Journal of Economic Dynamics & Control, 28, 1635–1660, 2005) and the empirical impulse response function is obtained by estimating a VAR model. In spite of the empirical finding, the results obtained from the proposed theoretical model show that the optimal response to a positive shock in long-term interest rate is a reduction in the short-term and an economic rationale of this finding is suggested.