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Optimal Operational Monetary Policy in the Christiano-Eichenbaum-Evans Model of the U.S. Business Cycle

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  • Stephanie Schmitt-Grohe
  • Martin Uribe

Abstract

This paper identifies optimal interest-rate rules within a rich, dynamic, general equilibrium model that has been shown to account well for observed aggregate dynamics in the postwar United States. We perform policy evaluations based on second-order accurate approximations to conditional and unconditional expected welfare. We require that interest-rate rules be operational, in the sense that they include as arguments only a few readily observable macroeconomic indicators and respect the zero bound on nominal interest rates. We find that the optimal operational monetary policy is a real-interest-rate targeting rule. That is, an interest-rate feedback rule featuring a unit inflation coefficient, a mute response to output, and no interest-rate smoothing. Contrary to existing studies, we find a significant degree of optimal inflation volatility. A key factor driving this result is the assumption of indexation to past inflation. Under indexation to long-run inflation the optimal inflation volatility is close to zero. Finally, we show that initial conditions matter for welfare rankings of policies.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 10724.

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Date of creation: Sep 2004
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Handle: RePEc:nbr:nberwo:10724

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  2. Robert Kollmann, 2004. "Welfare Maximizing Monetary and Fiscal Policy Rules," Computing in Economics and Finance 2004 102, Society for Computational Economics.
  3. Martin Uribe & Stephanie Schmitt-Grohe, 2001. "Optimal fiscal and monetary policy under sticky prices," Proceedings, Federal Reserve Bank of San Francisco, issue Jun.
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  9. Christopher J. Erceg & Dale W. Henderson & Andrew T. Levin, 1999. "Optimal monetary policy with staggered wage and price contracts," International Finance Discussion Papers 640, Board of Governors of the Federal Reserve System (U.S.).
  10. Stephanie Schmitt-Grohe & Martin Uribe, 2002. "Solving Dynamic General Equilibrium Models Using a Second-Order Approximation to the Policy Function," NBER Technical Working Papers 0282, National Bureau of Economic Research, Inc.
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  21. Jinill Kim & Sunghyun Kim & Ernst Schaumburg & Christopher A. Sims, 2003. "Calculating and Using Second Order Accurate Solutions of Discrete Time," Levine's Bibliography 666156000000000284, UCLA Department of Economics.
  22. Yun, Tack, 1996. "Nominal price rigidity, money supply endogeneity, and business cycles," Journal of Monetary Economics, Elsevier, vol. 37(2-3), pages 345-370, April.
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