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Optimal State-dependent Monetary Policy Rules

  • Christian Baker

    (Department of Economics, Brigham Young University)

  • Richard W. Evans

    (Department of Economics, Brigham Young University)

This paper defines a monetary equilibrium and computes an optimal nonlinear, full-information, state-dependent monetary policy rule to which the monetary authority commits at the beginning of time. This type of optimal monetary policy represents a combination of the flexibility of discretion with the time consistency of commitment. The economic environment is a closed-economy general equilibrium model of incomplete markets with monopolistic competition, producer price stickiness, and a transaction cost motive for holding money. We prove existence and uniqueness of the competitive equilibrium given a monetary policy rule and prove existence of the optimal rule. We show that the optimal state-dependent monetary policy rule satisfies the standard results of the discretionary policy literature in that it keeps inflation and nominal interest rates low (Friedman rule) and reduces inefficient variance in prices. Lastly, we compare the optimal monetary policy rule to a limited-information Taylor rule. We find that the Taylor rule, based on observable macroeconomic variables, is able to closely approximate the economic outcomes of the model under the optimal full-information rule.

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File URL: https://docs.google.com/file/d/0B6KGaihAO5TJWFJOeG9jeGt1Q1E/edit
File Function: First version, 2013
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Paper provided by Brigham Young University, Department of Economics, BYU Macroeconomics and Computational Laboratory in its series BYU Macroeconomics and Computational Laboratory Working Paper Series with number 2013-04.

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Length: 37 pages
Date of creation: Oct 2013
Date of revision:
Handle: RePEc:byu:byumcl:201304
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  1. Taylor, John B, 1980. "Aggregate Dynamics and Staggered Contracts," Journal of Political Economy, University of Chicago Press, vol. 88(1), pages 1-23, February.
  2. V. V. Chari & Patrick J. Kehoe, 2006. "Modern macroeconomics in practice: how theory is shaping policy," Staff Report 376, Federal Reserve Bank of Minneapolis.
  3. Lawrence Christiano & Martin Eichenbaum & Sergio Rebelo, 2011. "When Is the Government Spending Multiplier Large?," Journal of Political Economy, University of Chicago Press, vol. 119(1), pages 78 - 121.
  4. V.V. Chari & Patrick J. Kehoe & Ellen R. McGrattan, 2008. "New Keynesian Models: Not Yet Useful for Policy Analysis," NBER Working Papers 14313, National Bureau of Economic Research, Inc.
  5. King, Robert G. & Wolman, Alexander L., 2004. "Monetary discretion, pricing complementarity and dynamic multiple equilibria," Working Paper Series 0343, European Central Bank.
  6. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
  7. Kydland, Finn E & Prescott, Edward C, 1977. "Rules Rather Than Discretion: The Inconsistency of Optimal Plans," Journal of Political Economy, University of Chicago Press, vol. 85(3), pages 473-91, June.
  8. Frank Smets & Rafael Wouters, 2007. "Shocks and Frictions in US Business Cycles: A Bayesian DSGE Approach," American Economic Review, American Economic Association, vol. 97(3), pages 586-606, June.
  9. Robert J. Barro & David B. Gordon, 1983. "Rules, Discretion and Reputation in a Model of Monetary Policy," NBER Working Papers 1079, National Bureau of Economic Research, Inc.
  10. Ireland, Peter N., 1997. "Sustainable monetary policies," Journal of Economic Dynamics and Control, Elsevier, vol. 22(1), pages 87-108, November.
  11. Lars Ljungqvist & Thomas J. Sargent, 2004. "Recursive Macroeconomic Theory, 2nd Edition," MIT Press Books, The MIT Press, edition 2, volume 1, number 026212274x, June.
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