TAILIEUCHUNG - Incomplete Interest Rate Pass-Through and Optimal Monetary Policy∗

The Basel Committee on Banking Supervision, after an extensive consultation process, redrafted its recommendations for credit institutions’ regulatory capital requirements (Basel I) issued in 1988. The revision was motivated by the wish to adequately refl ect current developments in banking and to strengthen the stability of the international fi nancial system. On Novem - ber 15, 2005, the Basel Committee on Banking Supervision presented the revised version of the “Basel II” Capital Accord’s framework agreement, ini- tially released under the title “International Convergence of Capital Measure- ment and Capital Requirements” on June 26, 2004. The major difference between this document and the. | Incomplete Interest Rate Pass-Through and Optimal Monetary Policy 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. 1. Introduction Many empirical studies have shown that in the majority of industrialized countries a cost channel plays an important role in the I would like to thank Yuichi Abiko Ippei Fujiwara Ichiro Fukunaga Hibiki Ichiue Toshiki Jinushi Takeshi Kudo Ryuzo Miyao Ichiro Muto Ryuichi Naka-gawa Masashi Saito Yosuke Takeda Peter Tillmann Takayuki Tsuruga Kazuo Ueda Tsutomu Watanabe Hidefumi Yamagami other seminar participants at Kobe University and the University of Tokyo and anonymous referees for their valuable comments and suggestions. A part of this research was supported by KAKENHI Grant-in-Aid for Young Scientists B 17730138. Author contact Department of Economics Chukyo University 101-2 Yagoto-honmachi Showa-ku Nagoya 466-8666 Japan. E-mail kteru@. Tel. Fax 8152-835-7943. 77 78 International Journal of Central Banking September 2008 transmission of monetary Along with this many authors have attempted to incorporate a cost channel in formal models of monetary policy. For example .

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