Working Paper Series no. 161: Bubble-free interest-rate rules

Abstract

This paper designs, for a broad class of rational-expectations dynamic stochastic general-equilibrium models, interest-rate rules which not only ensure the local determinacy of the targeted equilibrium within the neighbourhood of the targeted steady state, but also prevent the economy from gradually leaving this neighbourhood. We show that in most models these interest-rate rules are necessarily forward-looking (i.e. make necessarily the interest rate conditional on the private agents' expectations), while in all models non-forward-looking interest-rate rules exist which ensure only the local determinacy of the targeted equilibrium. We also discuss the robustness of the effectiveness of these rules to departures from various assumptions and show in particular that they can still be effective when the central bank has imperfect knowledge of the model's structural parameters. We finally argue that such rules could also serve as a useful guide in the reflections on the best monetary policy reaction to perceived asset-price bubbles or exchange-rate misalignments.

Olivier Loisel
December 2006

Classification JEL : E52, E61

Keywords : DSGE models, interest-rate rules, local determinacy, global determinacy, rational bubbles.