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Optimal Monetary Policy in a Simple Distorted Economy

In this paper I search for an optimal configurations of parameters for variants of the Taylor rule by using an Accurate Second-Order Welfare based method within a fully microfounded Dynamic Stochastic model, with price rigidities, without capital accumulation. Money is inserted via a transaction cost function, price rigidities are modelled via quadratic cost of price adjustment. A version of the model with distortionary taxation is also explicitly tested. The model is solved up to Second Order solution. Optimal rules are obtained by maximizing a conditional welfare measure, differently from what has been done in the current literature. Optimal monetary policy functions turn out to be characterized by inflation targeting parameter lower than in empirical studies. In general, the optimal values for moentary policy parameters depend from the degree of nominal rigidities and from the role of fiscal policy. When nominal rigidities are higher, optimal monetary policy becomes more aggressive towards infla on. With a tigther fiscal policy, optimal monetary policy turns out to be less inflation-aggressive. Moreover, the results show that relying conditional welfare measure avoids the problems related with first-order or unconditional welfare measures. Impulse Response functions based on second order model solution show a non-aef ne pattern when the economy is hit by shocks of different magnitude.

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Paper provided by Dipartimento Scienze Economiche, Universita' di Bologna in its series Working Papers with number 511.

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Date of creation: 2004
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Handle: RePEc:bol:bodewp:511
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  1. Clarida, R. & Gali, J. & Gertler, M., 1998. "Monetary Policy Rules and Macroeconomic Stability: Evidence and some Theory," Working Papers 98-01, C.V. Starr Center for Applied Economics, New York University.
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  4. Obstfeld, Maurice & Rogoff, Kenneth, 2001. "Global Implications of Self-Oriented National Monetary Rules," Center for International and Development Economics Research, Working Paper Series qt6412m5b7, Center for International and Development Economics Research, Institute for Business and Economic Research, UC Berkeley.
  5. Stephanie Schmitt-Grohe & Martin Uribe, 2004. "Optimal Simple and Implementable Monetary and Fiscal Rules," NBER Working Papers 10253, National Bureau of Economic Research, Inc.
  6. Schmitt-Grohe, Stephanie & Uribe, Martin, 2004. "Optimal fiscal and monetary policy under sticky prices," Journal of Economic Theory, Elsevier, vol. 114(2), pages 198-230, February.
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  8. Sutherland, Alan, 2002. "A Simple Second-Order Solution Method For Dynamic General Equilibrium Models," CEPR Discussion Papers 3554, C.E.P.R. Discussion Papers.
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  11. Hairault, J.O. & Portier, F., 1992. "Money New-Keynesian Macroeconomics and the Business Cycles," Papiers d'Economie Mathématique et Applications 92.32, Université Panthéon-Sorbonne (Paris 1).
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  13. Lawrence J. Christiano & Martin Eichenbaum & Charles L. Evans, 2001. "Nominal rigidities and the dynamic effects of a shock to monetary policy," Working Paper Series WP-01-08, Federal Reserve Bank of Chicago.
  14. 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.
  15. Hansen, Lars Peter, 1982. "Large Sample Properties of Generalized Method of Moments Estimators," Econometrica, Econometric Society, vol. 50(4), pages 1029-54, July.
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  17. Julio Rotemberg & Michael Woodford, 1997. "An Optimization-Based Econometric Framework for the Evaluation of Monetary Policy," NBER Chapters, in: NBER Macroeconomics Annual 1997, Volume 12, pages 297-361 National Bureau of Economic Research, Inc.
  18. Marvin Goodfriend & Robert G. King, 1998. "The new neoclassical synthesis and the role of monetary policy," Working Paper 98-05, Federal Reserve Bank of Richmond.
  19. Ireland, Peter N., 1997. "A small, structural, quarterly model for monetary policy evaluation," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 47(1), pages 83-108, December.
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  21. Jinill Kim & Sunghyun Kim & Ernst Schaumburg & Christopher A. Sims, 2003. "Calculating and Using Second Order Accurate Solutions of Discrete Time," Levine's Bibliography 666156000000000284, UCLA Department of Economics.
  22. Lee E. Ohanian & Alan C. Stockman & Lutz Kilian, 1994. "The effects of real and monetary shocks in a business cycle model with some sticky prices," Proceedings, Federal Reserve Bank of Cleveland, pages 1209-1240.
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  24. Leeper, Eric M., 1991. "Equilibria under 'active' and 'passive' monetary and fiscal policies," Journal of Monetary Economics, Elsevier, vol. 27(1), pages 129-147, February.
  25. Kim, Jinill, 2000. "Constructing and estimating a realistic optimizing model of monetary policy," Journal of Monetary Economics, Elsevier, vol. 45(2), pages 329-359, April.
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