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Optimal monetary policy

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Author Info
Aubhik Khan
Robert G. King
Alexander L. Wolman

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Abstract

Optimal monetary policy maximizes welfare, given frictions in the economic environment. Constructing a model with two sets of frictions - the Keynesian friction of costly price adjustment by imperfectly competitive firms and the Monetarist friction of 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. (In modern language, there is only small "base drift" for the price level 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 - as there is expected growth or contraction of real economic activity.

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Paper provided by Federal Reserve Bank of Richmond in its series Working Paper with number 00-10.

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Date of creation: 2000
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Handle: RePEc:fip:fedrwp:00-10

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Keywords: Monetary policy Prices Inflation (Finance)

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References listed on IDEAS
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  4. Lacker, Jeffrey M. & Schreft, Stacey L., 1996. "Money and credit as means of payment," Journal of Monetary Economics, Elsevier, vol. 38(1), pages 3-23, August. [Downloadable!] (restricted)
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  6. Basu, Susanto & Fernald, John G, 1997. "Returns to Scale in U.S. Production: Estimates and Implications," Journal of Political Economy, University of Chicago Press, vol. 105(2), pages 249-83, April.
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  7. Marvin Goodfriend & Robert G. King, 2001. "The case for price stability," Working Paper 01-02, Federal Reserve Bank of Richmond. [Downloadable!]
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  29. Miles S. Kimball & Michael Woodford, 1994. "The quantitative analysis of the basic neomonetarist model," Proceedings, Federal Reserve Bank of Cleveland, pages 1241-1289.
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  30. Marvin Goodfriend & Robert G. King, 1998. "The new neoclassical synthesis and the role of monetary policy," Working Paper 98-05, Federal Reserve Bank of Richmond. [Downloadable!]
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