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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.

Suggested Citation

  • Christian Baker & Richard W. Evans, 2013. "Optimal State-dependent Monetary Policy Rules," BYU Macroeconomics and Computational Laboratory Working Paper Series 2013-04, Brigham Young University, Department of Economics, BYU Macroeconomics and Computational Laboratory.
  • Handle: RePEc:byu:byumcl:201304

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    References listed on IDEAS

    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. Barro, Robert J. & Gordon, David B., 1983. "Rules, discretion and reputation in a model of monetary policy," Journal of Monetary Economics, Elsevier, vol. 12(1), pages 101-121.
    3. V. V. Chari & Patrick J. Kehoe & Ellen R. McGrattan, 2009. "New Keynesian Models: Not Yet Useful for Policy Analysis," American Economic Journal: Macroeconomics, American Economic Association, vol. 1(1), pages 242-266, January.
    4. Lars Ljungqvist & Thomas J. Sargent, 2004. "Recursive Macroeconomic Theory, 2nd Edition," MIT Press Books, The MIT Press, edition 2, volume 1, number 026212274x, July.
    5. 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.
    6. Robert G. King & Alexander L. Wolman, 2004. "Monetary Discretion, Pricing Complementarity, and Dynamic Multiple Equilibria," The Quarterly Journal of Economics, Oxford University Press, vol. 119(4), pages 1513-1553.
    7. V. V. Chari & Patrick J. Kehoe, 2006. "Modern Macroeconomics in Practice: How Theory Is Shaping Policy," Journal of Economic Perspectives, American Economic Association, vol. 20(4), pages 3-28, Fall.
    8. King, Robert G. & Wolman, Alexander L., 2004. "Monetary discretion, pricing complementarity and dynamic multiple equilibria," Working Paper Series 343, European Central Bank.
    9. Ireland, Peter N., 1997. "Sustainable monetary policies," Journal of Economic Dynamics and Control, Elsevier, vol. 22(1), pages 87-108, November.
    10. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
    11. 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.
    12. 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 473-491, June.
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    More about this item


    Optimal monetary policy; Money supply rules; Time consistency; Nonlinear solution methods;

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E42 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Monetary Sytsems; Standards; Regimes; Government and the Monetary System
    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • C68 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Computable General Equilibrium Models

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