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Optimal choice of monetary policy instruments in an economy with real and liquidity shocks

  • Bhattacharya, Joydeep
  • Singh, Rajesh

Faced with real and nominal shocks, what should a benevolent central bank do, fix the money growth rate or target the inflation rate? In this paper, we make a first attempt at studying the optimal choice of monetary policy instruments in a micro-founded model of money. Specifically, we produce an overlapping generations economy in which limited communication and stochastic relocation creates an endogenous transactions role for fiat money. We find that when the shocks are real, welfare is higher under money growth targeting; when the shocks are nominal and not large, welfare is higher under inflation targeting. While under inflation targeting, it is always optimal to pursue an expansionary policy, it is never optimal to do so under money growth targeting.

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Article provided by Elsevier in its journal Journal of Economic Dynamics and Control.

Volume (Year): 32 (2008)
Issue (Month): 4 (April)
Pages: 1273-1311

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Handle: RePEc:eee:dyncon:v:32:y:2008:i:4:p:1273-1311
Contact details of provider: Web page: http://www.elsevier.com/locate/jedc

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  1. Stacey Schreft & Bruce Smith, 2008. "The social value of risk-free government debt," Annals of Finance, Springer, vol. 4(2), pages 131-155, March.
  2. Townsend, Robert M, 1987. "Economic Organization with Limited Communication," American Economic Review, American Economic Association, vol. 77(5), pages 954-71, December.
  3. Schreft, Stacey L. & Smith, Bruce D., 1997. "Money, Banking, and Capital Formation," Journal of Economic Theory, Elsevier, vol. 73(1), pages 157-182, March.
  4. Bhattacharya, Joydeep & Haslag, Joseph & Russell, Steven, 2005. "The role of money in two alternative models: When is the Friedman rule optimal, and why?," Journal of Monetary Economics, Elsevier, vol. 52(8), pages 1401-1433, November.
  5. Bhattacharya, Joydeep & Singh, Rajesh, 2006. "On the Usefulness of the Constrained Planning Problem in a Model of Money," Staff General Research Papers 12660, Iowa State University, Department of Economics.
  6. Bruce Champ & Bruce D. Smith & Stephen D. Williamson, 1996. "Currency Elasticity and Banking Panics: Theory and Evidence," Canadian Journal of Economics, Canadian Economics Association, vol. 29(4), pages 828-64, November.
  7. Bruce D. Smith, 2002. "Monetary Policy, Banking Crises, and the Friedman Rule," American Economic Review, American Economic Association, vol. 92(2), pages 128-134, May.
  8. Gomis-Porqueras, Pere & Smith, Bruce D., 2003. "Seasonality And Monetary Policy," Macroeconomic Dynamics, Cambridge University Press, vol. 7(04), pages 477-502, September.
  9. Gaetano Antinolfi & Todd Keister, 2003. "Discount Window Policy, Banking Crises, and Indeterminacy of Equilibrium," Working Papers 0305, Centro de Investigacion Economica, ITAM.
  10. Joe Haslag & Antoine Martin, 2003. "Optimality of the Friedman Rule in Overlapping Generations Model with Spatial Separation," Working Papers 0306, Department of Economics, University of Missouri.
  11. William Poole, 1970. "Optimal choice of monetary policy instruments in a simple stochastic macro model," Staff Studies 57, Board of Governors of the Federal Reserve System (U.S.).
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