Efficiency and Stability Issues in Monetary Policy
This paper quantitatively evaluates the relative importance of the efficiency and stabilization effects of monetary policy. While maximum efficiency in the spirit of Friedman advocates long-run deflation so that the nominal interest rate is zero, business cycle consideration requires positive long-run inflation so that the nominal interest rate can be adjusted for stabilization without encountering the zero bound. In an estimated DSGE model for the US economy that can generate both effects, we find that the welfare-maximizing monetary policy rule is characterized with a steady-state inflation rate of 0.12% per annum, significantly above the rate required for maximal efficiency and significantly below what is believed to have been targeted by the Federal Reserve. It is also found that, if the monetary authority tries to minimize typical loss functions comprising volatilities of macro variables such as output and inflation, the resultant policy rules are flawed: they lead to too high long-run inflation and too much policy activism, compared to rules that maximize welfare.
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Volume (Year): 39 (2010)
Issue (Month): 4 ()
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