Inflation and interest rates in the presence of a cost channel, wealth effect and agent heterogeneity

As far as the control of inflation is concerned, the interest rate is the most important monetary instrument. This paper examines the effectiveness of the interest rate policy in controlling inflation. The model utilized in this paper considers both demand and supply side effects of interest rate policy. These effects are used to derive not only the relevant impulse response functions but also the welfare loss to the society that arises from the supply side shocks. Based on their ability to control inflation and minimization of the overall welfare loss to the society, three policies are compared: (i) monetary policy with commitment, (ii) Taylor's rule, and (iii) inflation targeting. We argue that, in the presence of a cost channel, it is imperative that the interest rate policy is used with restraint. Our results also suggest that ignoring the cost channel of monetary policy can lead to significant under-estimation of the social welfare loss.

► Effectiveness of the interest rate policy in controlling inflation is examined. ► Both demand and supply-side effects of interest rate policy are considered. ► Interest rate policy must be used with restraint when a cost channel is present. ► Society's social welfare loss is under-estimated, if the cost channel is ignored.