On Interest Rate Policies

The context in which the subject is treated is the different institutional arrangements that are being contemplated worldwide. Institutions, for the present purpose, are defined as outcomes of the strategic interaction between members of the private sector and the monetary authorities. In a generalisation of the credit transmission approach we consider an aggregate monetary economy consisting of three agents: a firm, a bank and a household. The relationship between pairs of them is characterised by bilateral private information. Bonds, loans and savings are contracts in the level of output, the rate of interest on bonds, loans and the deposit rate. It is shown that the contracts have a common functional form. This renders the model dynamically unstable. We consider the potentially stabilising role of monetary policy in two cases. In the first, the monetary authority operates the discount window. Formally, we introduce a parameter in the objective functions of the private sector agents. In the second, the central bank enters as a player with the interest rate on government paper as a strategy. We examine the relative merits of the two policy regimes.