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Optimal monetary policy

Author

Listed:
  • Aubhik Khan
  • Robert G. King
  • Alexander L. Wolman

Abstract

Optimal monetary policy maximizes welfare, given frictions in the economic environment. Constructing a model with two sets of frictions - the Keynesian friction of costly price adjustment by imperfectly competitive firms and the Monetarist friction of costly exchange of wealth for goods - we find optimal monetary policy is governed by two familiar 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). Since expected inflation is roughly constant through time, the nominal interest rate must therefore vary with the Fisherian determinants of the real interest rate - as there is expected growth or contraction of real economic activity.

Suggested Citation

  • Aubhik Khan & Robert G. King & Alexander L. Wolman, 2000. "Optimal monetary policy," Working Paper 00-10, Federal Reserve Bank of Richmond.
  • Handle: RePEc:fip:fedrwp:00-10
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    References listed on IDEAS

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    More about this item

    Keywords

    Monetary policy ; Prices ; Inflation (Finance);

    JEL classification:

    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit

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