Abstract: Since 1980s, the monetary policy framework in most developed countries and many middle-income countries has moved from targeting monetary aggregates to interest rates. During or after this transition, many countries adopted an interest rate corridor system. This paper builds a few theoretical models to investigate the operational mechanism of interest rate corridor systems. We find that: (1) A corridor system can reduce interest rate volatility by better guiding market expectations; (2) a corridor system can reduce and even eliminate the liquidity demand for hoarding and reduce the frequency, magnitude, and costs of the central bank's open market operations; and (3) the optimal width of an interest rate corridor is a function of interest rate volatility, the policy adjustment cost, as well as the frequency and size of external shocks. We suggest that China should adopt a corridor system, in order to control interest rate volatility, improve market recognition of the future policy rate, and provide a basis for effective policy rate transmission.

Full report ：Interest rate corridor, rate stability, and cost of central bank operations.pdf