Optimal monetary policy and the term structure of interest rates: a note

This paper derives the optimal monetary policy under discretion, taking into account that aggregate spending depends on the long‐term real interest rate rather than on the short‐term rate. It deduces optimal shock‐dependent strategies for the monetary instrument, the nominal interest rate and analyzes the influence of both the degree of persistence of supply and demand shocks and the weight on output stabilization in the objective function of the central bank on the optimal monetary reaction. The higher the degree of persistence of a supply shock, the stronger is the reaction of the interest rate, whereas the opposite holds for a demand shock. The reaction on demand disturbances is independent of weight given to output stabilization by the central bank; in the case of a supply shock the reaction of the interest rate depends on this weight.