September 2008 issue contents
Incomplete Interest Rate Pass-Through and Optimal Monetary Policy

by Teruyoshi Kobayashi
Department of Economics, Chukyo University


Many recent empirical studies have reported that the passthrough from money-market rates to retail lending rates is far from complete in the euro area. This paper formally shows that when only a fraction of all the loan rates is adjusted in response to a shift in the policy rate, fluctuations in the average loan rate lead to welfare costs. Accordingly, the central bank is required to stabilize the rate of change in the average loan rate in addition to inflation and output. It turns out that the requirement for loan rate stabilization justifies, to some extent, the idea of policy rate smoothing in the face of a productivity shock and/or a preference shock. However, a drastic policy reaction is needed in response to a shock that directly shifts retail loan rates, such as an unexpected shift in the loan rate premium.

JEL Codes: E44, E52, E58.

Full article (PDF, 42 pages 542 kb)