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Optimal monetary policy

  • Aubhik Khan
  • Robert King
  • Alexander L. Wolman

Optimal monetary policy maximizes the welfare of a representative agent, given frictions in the economic environment. Constructing a model with two broad sets of frictions — costly price adjustment by imperfectly competitive firms and costly exchange of wealth for goods — we find optimal monetary policy is governed by two familar principles. ; First, the average level of the nominal interest rate should be sufficiently low, as suggested by Milton Friedman, that there should be deflation on average. Yet, the Keynesian frictions imply that the optimal nominal interest rate is positive. ; Second, as various shocks occur to the real and monetary sectors, the price level should be largely stabilized, as suggested by Irving Fisher, albeit around a deflationary trend path. (In modern language, there is only small “base drift” for the price level path as various shocks arise). Since expected inflation is roughly constant through time, the nominal interest rate must therefore vary with the Fisherian determinants of the real interest rate, i.e., with expected growth or contraction of real economic activity. ; Although the monetary authority has substantial leverage over real activity in our model economy, it chooses real allocations that closely resemble those that would occur if prices were flexible. In our benchmark model, we also find some tendency for the monetary authority to smooth nominal and real interest rates.

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Paper provided by Federal Reserve Bank of Philadelphia in its series Working Papers with number 02-19.

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Date of creation: 2002
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Handle: RePEc:fip:fedpwp:02-19
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