Title: Taking two steps at a time: On the optimal step pattern of policy rates
Reference Number: 1074
Publication Date: October 2003
JEL Classifcation: E43, E58

Petra Gerlach-Kristen
The University of Hong Kong

Most central banks change interest rates in steps of 25, 50 or 75 basis points at scheduled dates. This paper presents a model that determines optimally the step size and the frequency of policy decisions. In contrast to the existing literature we argue that the size of interest rate changes is chosen to help focus policy decisions, which we assume are taken by a Monetary Policy Committee. Moreover, we assume that the preparations of policy meetings are costly and that decisions therefore are scheduled such that an interest rate change is likely. The analysis indicates that the step pattern depends on the variability of the unobserved optimal level of interest rates, policymakers' difficulties observing it and their preferences. The model expands the literature by predicting occasional policy rate adjustments by two steps at a time.

Revised May 20, 2004

Key words: interest rate steps, monetary policy committees

Last modified: 06/26/2004