Inflation and interest rates in the presence of a cost channel,wealth effect and agent heterogeneity |
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| Affiliation: | 1. Department of Economics, Lahore University of Management Sciences, Lahore Cantt 54792, Pakistan;2. School of Business, University of the Sunshine Coast, Maroochydore DC, QLD 4558, Australia;3. Bond University, Gold Coast Australia;1. College of Economics and Management, Nanjing University of Aeronautics and Astronautics, 211106 Nanjing, China;2. Energy Soft Science Center, Nanjing University of Aeronautics and Astronautics, 211106 Nanjing, China;3. School of Modern Languages, Newcastle University, NE1 7RU Newcastle, UK;4. English Department, Nanhang Jincheng College, 211156 Nanjing, China;1. Research Institute of Physiology and Basic Medicine, Timakova, 4, Novosibirsk 630117, Russia;2. Novosibirsk State University, Russian Federation;3. Kyoto Aikido Mugenjuku, Kyoto, Japan;1. College of Chemistry & Chemical Engineering, Shanxi University, Taiyuan, Shanxi 030006, PR China;2. Institute of Resources and Environment Engineering, Shanxi University, Taiyuan, Shanxi 030006, PR China;3. China Research Institute of Daily Chemical Industry, Taiyuan, Shanxi 030001, PR China |
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| Abstract: | As far as the control of inflation is concerned, the interest rate is the most important monetary instrument. This paper examines the effectiveness of the interest rate policy in controlling inflation. The model utilized in this paper considers both demand and supply side effects of interest rate policy. These effects are used to derive not only the relevant impulse response functions but also the welfare loss to the society that arises from the supply side shocks. Based on their ability to control inflation and minimization of the overall welfare loss to the society, three policies are compared: (i) monetary policy with commitment, (ii) Taylor's rule, and (iii) inflation targeting. We argue that, in the presence of a cost channel, it is imperative that the interest rate policy is used with restraint. Our results also suggest that ignoring the cost channel of monetary policy can lead to significant under-estimation of the social welfare loss. |
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