We argue that an increase in aggregate demand can lead to a reduction in the interest rate.
This apparently perverse optimal response of interest rates can occur when the Phillips curve
is non-linear. In that case, an increase in aggregate demand tends to increase inflation and
output but also to change the weight on inflation in the optimal monetary policy rule. Although
the first two effects tend to increase interest rates, the latter effect can imply lower interest
rates. If this effect dominates, interest rates can fall