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Optimal Monetary Policy in the Sticky Information Model of Price Adjustment: Inflation Targeting or Price-Level Targeting?

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  • Arslan, Mesut Murat

Abstract

I investigate optimal monetary policy in the sticky information model of price adjustment within a New Keynesian macroeconomic framework. The model is solved for optimal policy, and welfare implications of three alternative monetary policy regimes: unconstrained policy, price-level targeting and inflation targeting, are compared when there is a shock to the economy. The results for a cost-push shock illustrate that optimal policy depends on the degree of price stickiness and the persistence of the shock. Inflation targeting is the optimal policy if prices are flexible enough or the shock is persistent enough. However, for a demand shock, inflation targeting emerges as the best policy for all values of the price stickiness and the shock's persistence. When the volatility of nominal interest rate is taken into consideration, the results indicate that inflation targeting is the best policy, in the sense that it results in smaller welfare loss and volatility of nominal interest rate, if prices are sticky enough and the persistence of the shock is large enough. However, price-level targeting might be preferable to inflation targeting if prices are more flexible and the relative weight for the volatility of nominal interest rate is large.

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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 5271.

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Date of creation: Aug 2006
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Handle: RePEc:pra:mprapa:5271

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Related research

Keywords: Optimal policy; Sticky information; Inflation targeting; Price-level targeting;

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  1. Julio J. Rotemberg & Michael Woodford, 1999. "Interest Rate Rules in an Estimated Sticky Price Model," NBER Chapters, in: Monetary Policy Rules, pages 57-126 National Bureau of Economic Research, Inc.
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  3. Svensson, Lars E O & Woodford, Michael, 2004. "Implementing Optimal Policy Through Inflation-Forecast Targeting," CEPR Discussion Papers, C.E.P.R. Discussion Papers 4229, C.E.P.R. Discussion Papers.
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  12. Richard Clarida & Jordi Gali & Mark Gertler, 2001. "Optimal Monetary Policy in Open versus Closed Economies: An Integrated Approach," American Economic Review, American Economic Association, American Economic Association, vol. 91(2), pages 248-252, May.
  13. Ben S. Bernanke & Ilian Mihov, 1998. "Measuring Monetary Policy," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 113(3), pages 869-902, August.
  14. Jordi Galí & Tommaso Monacelli, 2004. "Monetary policy and exchange rate volatility in a small open economy," Economics Working Papers, Department of Economics and Business, Universitat Pompeu Fabra 835, Department of Economics and Business, Universitat Pompeu Fabra.
  15. Lars E.O. Svensson, 2002. "Inflation Targeting: Should It Be Modeled as an Instrument Rule or a Targeting Rule?," NBER Working Papers 8925, National Bureau of Economic Research, Inc.
  16. Lars E. O. Svensson, 2003. "What is Wrong with Taylor Rules? Using Judgment in Monetary Policy through Targeting Rules," NBER Working Papers 9421, National Bureau of Economic Research, Inc.
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