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Inflation Stabilization and Welfare

  • Woodford Michael

    ()

    (Princeton University)

This paper derives loss functions for analyses of optimal monetary policy that are grounded in the welfare of private agents, in the case of explicit optimizing models of private-sector behavior in which the real effects of monetary policy result from nominal price rigidity. A quadratic approximation to the utility-based welfare criterion is developed that allows comparison between this criterion and the ad hoc quadratic loss functions typically assumed in the literature on monetary policy evaluation. It is shown that the goal of inflation stabilization, generally presumed to be an important (and perhaps the preeminent) goal of monetary policy, can in fact be justified in such a framework, insofar as variable inflation results in real distortions when prices are not adjusted throughout the economy in a perfectly synchronized fashion. The exact sense in which inflation variability matters for welfare, however, depends upon the details of price-setting behavior.

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Article provided by De Gruyter in its journal The B.E. Journal of Macroeconomics.

Volume (Year): 2 (2002)
Issue (Month): 1 (February)
Pages: 1-53

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Handle: RePEc:bpj:bejmac:v:contributions.2:y:2002:i:1:n:1
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  1. Woodford, Michael, 1990. "The optimum quantity of money," Handbook of Monetary Economics, in: B. M. Friedman & F. H. Hahn (ed.), Handbook of Monetary Economics, edition 1, volume 2, chapter 20, pages 1067-1152 Elsevier.
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  9. Jinill Kim & Sunghyun Henry Kim, 1999. "Spurious Welfare Reversals in International Business Cycle Models," Virginia Economics Online Papers 319, University of Virginia, Department of Economics.
  10. William Poole, 1999. "Monetary policy rules?," Review, Federal Reserve Bank of St. Louis, issue Mar, pages 3-12.
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  19. Richard Clarida & Jordi Galí & Mark Gertler, 1997. "The science of monetary policy: A new Keynesian perspective," Economics Working Papers 356, Department of Economics and Business, Universitat Pompeu Fabra, revised Apr 1999.
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  21. 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.).
  22. Aiyagari, S. Rao & Braun, R. Anton, 1998. "Some models to guide monetary policymakers," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 48(1), pages 1-42, June.
  23. Dupor, Bill, 2003. "Optimal random monetary policy with nominal rigidity," Journal of Economic Theory, Elsevier, vol. 112(1), pages 66-78, September.
  24. Benigno, Pierpaolo, 2004. "Optimal monetary policy in a currency area," Journal of International Economics, Elsevier, vol. 63(2), pages 293-320, July.
  25. Amato, Jeffery D. & Laubach, Thomas, 2003. "Rule-of-thumb behaviour and monetary policy," European Economic Review, Elsevier, vol. 47(5), pages 791-831, October.
  26. Jón Steinsson, 2000. "Optimal monetary policy in an economy with inflation persistence," Economics wp11, Department of Economics, Central bank of Iceland.
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  29. Taylor, John B, 1980. "Aggregate Dynamics and Staggered Contracts," Journal of Political Economy, University of Chicago Press, vol. 88(1), pages 1-23, February.
  30. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
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