Journal Article

Optimal Monetary Policy

Aubhik Khan, Robert G. King and Alexander L. Wolman

in The Review of Economic Studies

Published on behalf of Review of Economic Studies Ltd

Volume 70, issue 4, pages 825-860
Published in print October 2003 | ISSN: 0034-6527
Published online October 2003 | e-ISSN: 1467-937X | DOI: http://dx.doi.org/10.1111/1467-937X.00269
Optimal Monetary Policy

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  • Prices, Business Fluctuations, and Cycles
  • Monetary Policy, Central Banking, and the Supply of Money and Credit
  • Money and Interest Rates

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Optimal monetary policy maximizes the welfare of a representative agent, given frictions in the economic environment. Constructing a model with two sets of frictions—costly price adjustment by imperfectly competitive firms and costly exchange of wealth for goods—we find optimal monetary policy is governed by two familiar principles. First, the average level of the nominal interest rate should be sufficiently low, as suggested by Milton Friedman, that there should be deflation on average. Yet, the Keynesian frictions imply that the optimal nominal interest rate is positive. Second, as various shocks occur to the real and monetary sectors, the price level should be largely stabilized, as suggested by Irving Fisher, albeit around a deflationary trend path. Since expected inflation is roughly constant through time, the nominal interest rate must therefore vary with the Fisherian determinants of the real interest rate. Although the monetary authority has substantial leverage over real activity in our model economy, it chooses real allocations that closely resemble those which would occur if prices were flexible. In our benchmark model, there is some tendency for the monetary authority to smooth nominal and real interest rates.

Keywords: E31; E43; E52

Journal Article.  14811 words.  Illustrated.

Subjects: Prices, Business Fluctuations, and Cycles ; Monetary Policy, Central Banking, and the Supply of Money and Credit ; Money and Interest Rates

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