Real interest rates and central bank operating procedures

Abstract

We use consumption-based CAPM models (with fixed and flexible wages) to analyze the effect of central bank operating procedures on the ex ante real rate of return on a one-period nominal bond. We show that operating procedures affect both the risk-free rate and the risk premium. Nominal interest rate targeting produces the highest real interest rates; money targeting produces the lowest rates; and nominal income targeting comes out somewhere in between. Our simulations suggest that the central bank's choice of operating procedure may make as much as 50 or 100 basis points difference in the real rate of interest. The role of monetary aggregates has diminished in most central banks' operating procedures, and this provides one explanation for the common perception that real interest rates may have risen. Nevertheless, our analysis also demonstrates that there is no presumption that monetary targeting dominates from a welfare point of view.