On the Optimality of Interest Rate Smoothing, Journal of Monetary Economics
This paper studies some continuous-time cash-in-advance models in which interest rate smoothing is optimal. We consider both deterministic and stochastic models. In the stochastic case we obtain two results of independent interest: (i) we study what is, to our knowledge, the only version of the neoclassical model under uncertainty that can be solved in closed form in continuous time; and (ii) we show how to characterize the competitive equilibrium of a stochastic continuous time model that cannot be computed by solving a planning problem. We also discuss the scope for monetary policy to improve welfare in an economy with a suboptimal real competitive equilibrium, focusing on the particular example of an economy with externalities.
Sergio Rebelo, Danyang Xie
Rebelo, Sergio, and Danyang Xie. 1999. On the Optimality of Interest Rate Smoothing. Journal of Monetary Economics. 43(2): 263-282.