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Inflation risk and optimal monetary policy

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  • William T. Gavin
  • Benjamin D. Keen
  • Michael R. Pakko

Abstract

This paper shows that the optimal monetary policies recommended by New Keynesian models still imply a large amount of inflation risk. We calculate the term structure of inflation uncertainty in New Keynesian models when the monetary authority adopts the optimal policy. When the monetary policy rules are modified to include some weight on a price path, the economy achieves equilibria with substantially lower long-run inflation risk. With either sticky prices or sticky wages, a price path target reduces the variance of inflation by an order of magnitude more than it increases the variability of the output gap.

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Bibliographic Info

Paper provided by Federal Reserve Bank of St. Louis in its series Working Papers with number 2006-035.

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Date of creation: 2007
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Handle: RePEc:fip:fedlwp:2006-035

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Keywords: Monetary policy ; Inflation (Finance);

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Cited by:
  1. Hatcher, Michael C., 2011. "Comparing inflation and price-level targeting: A comprehensive review of the literature," Cardiff Economics Working Papers E2011/22, Cardiff University, Cardiff Business School, Economics Section.
  2. Benjamin D. Keen & Michael R. Pakko, 2007. "Monetary policy and natural disasters in a DSGE model: how should the Fed have responded to Hurricane Katrina?," Working Papers 2007-025, Federal Reserve Bank of St. Louis.

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