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Optimal Choice of Monetary Policy Instruments in a Macroeconometric Model

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  • Ray C. Fair

Abstract

This paper uses stochastic simulation and my U.S. econometric model to examine the optimal choice of monetary policy instruments. Are the variances, covariances, and parameters in the model such as to favor one instrument over the other, in particular the interest rate over the money supply? The results show that the interest rate and the money supply are about equally good as policy instruments in terms of minimizing the variance of real GNP. The variances of some of the components of GNP are, however, much larger when the money supply is the policy instrument, as is the variance of the change in stock prices. Therefore, if one's loss function is expanded beyond simply the variance of real GNP to variances of other variables, the interest rate policy does better. The results thus provide some support for what seems to be the Fed's current choice of using the interest rate as its primary instrument. Stochastic simulation is also used to estimate how much of the variance of real GNP is due to the error terms in the demand for money equations. The results show that the contribution is not very great even when the money supply is the policy instrument .

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 2150.

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Date of creation: Jan 1987
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Publication status: published as Journal of Monetary Economics, Vol.XXII, No.2, pp.301-315, September 1988.
Handle: RePEc:nbr:nberwo:2150

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  1. William Poole, 1970. "Optimal choice of monetary policy instruments in a simple stochastic macro model," Staff Studies, Board of Governors of the Federal Reserve System (U.S.) 57, Board of Governors of the Federal Reserve System (U.S.).
  2. Yoshikawa, Hiroshi, 1981. "Alternative Monetary Policies and Stability in a Stochastic Keynesian Model," 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. 22(3), pages 541-65, October.
  3. Turnovsky, Stephen J, 1975. "Optimal Choice of Monetary Instrument in a Linear Economic Model with Stochastic Coefficients," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 7(1), pages 51-80, February.
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Cited by:
  1. Dag Kolsrud, 2008. "Stochastic Ceteris Paribus Simulations," Computational Economics, Society for Computational Economics, Society for Computational Economics, vol. 31(1), pages 21-43, February.

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