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Instrument Versus Target Rules As Specifications of Optimal Monetary Policy: What are the Issues, If Any?

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One issue in the literature on monetary policy in New Keynesian models has been the relative merits of instrument versus target rules. This paper focuses on optimal instrument and target rules within three workhorse models in the literature: IS-LM, AS-AD and the New Keynesian model. The focus on optimal rules enables us to exploit the equivalence among alternative expressions of optimal policies for a given information set. We find that in the AD-AS model, characterized by the presence of observable information variables and unobservable target variables, an optimal explicit instrument rule, a combination policy, and a target rule produce identical outcomes for the target variables. In the New Keynesian model, the optimal explicit instrument rule achieves the same stabilization results as the globally optimal target rule. However, the latter approach provides a more direct rationale for introducing inertia into policymaking. This seems to be the key advantage of the target rule approach. Along other dimensions such as robustness and transparency, target rules offer no clear advantages over optimal instrument rules.

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File URL: http://www.econ.canterbury.ac.nz/RePEc/cbt/econwp/1120.pdf
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Paper provided by University of Canterbury, Department of Economics and Finance in its series Working Papers in Economics with number 11/20.

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Length: 35 pages
Date of creation: 01 Feb 2011
Date of revision:
Handle: RePEc:cbt:econwp:11/20

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  1. Ravenna, Federico & Walsh, Carl E., 2006. "Optimal monetary policy with the cost channel," Journal of Monetary Economics, Elsevier, Elsevier, vol. 53(2), pages 199-216, March.
  2. Alfred V. Guender, 2006. "Stabilising Properties of Discretionary Monetary Policies in a Small Open Economy," Economic Journal, Royal Economic Society, Royal Economic Society, vol. 116(508), pages 309-326, 01.
  3. Poole, William, 1970. "Optimal Choice of Monetary Policy Instruments in a Simple Stochastic Macro Model," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 84(2), pages 197-216, May.
  4. Weiss, Laurence M, 1980. "The Role for Active Monetary Policy in a Rational Expectations Model," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 88(2), pages 221-33, April.
  5. LeRoy, Stephen F & Waud, Roger N, 1977. "Applications of the Kalman Filter in Short-Run Monetary Control," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 18(1), pages 195-207, February.
  6. Bennett T. McCallum, . "Recent Developments in monetary policy analysis: The roles of theory and evidence," GSIA Working Papers, Carnegie Mellon University, Tepper School of Business 1999-12, Carnegie Mellon University, Tepper School of Business.
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