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The choice of a monetary policy reaction function in a simple optimizing model

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  • Dale W. Henderson
  • Jinill Kim

Abstract

Monetary policy reaction functions are compared in a simple optimizing model with one-period nominal stickiness, i.i.d. shocks, and no capital accumulation. The interest rate is the instrument and is either kept constant, \"interest rate targeting\" for short, or used in targeting one of the following: money, the price level, output, nominal income (output), money growth, inflation, and the sum of inflation and output. There are three varieties of one-period nominal stickiness---wage stickiness, wage and price stickiness, and price stickiness---and three kinds of shocks---money demand shocks, goods demand shocks, and productivity shocks. A given type of targeting is \"better\" than some other type for a given variable and kind of shock if it results in smaller deviations of the variable from its target value. Some familiar results regarding the ranking of types of targeting are confirmed in the optimizing model, and some new results are obtained. It is not surprising that rankings may depend both on the type of shock and on which variable is the target variable. However, it may be somewhat surprising that, given that wages are sticky, rankings depend on whether prices are sticky, but that given that prices are sticky rankings do not depend on whether wages are sticky.

Suggested Citation

  • Dale W. Henderson & Jinill Kim, 1998. "The choice of a monetary policy reaction function in a simple optimizing model," International Finance Discussion Papers 601, Board of Governors of the Federal Reserve System (U.S.).
    • Handle: RePEc:fip:fedgif:601
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    References listed on IDEAS

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    1. Erceg, Christopher J. & Henderson, Dale W. & Levin, Andrew T., 1998. "Tradeoffs Between Inflation and Output-Gap Variances in an Optimizing-Agent Model," Seminar Papers 650, Stockholm University, Institute for International Economic Studies.
    2. Jean-Pascal Bénassy, 2006. "Interest rate rules, inflation and the Taylor principle: an analytical exploration," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 27(1), pages 143-162, January.

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    Monetary policy; Econometric models;

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