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Optimal Choice of Monetary Instruments in an Economy with Real and Liquidity Shocks

  • Bhattacharya, Joydeep
  • Singh, Rajesh

Faced with real and nominal shocks, what should a benevolent central bank do, fix the money growth rate or target the inflation rate? In this paper, we make a first attempt at studying the optimal choice of monetary policy instruments in a micro-founded model of money. Specifically, we produce an overlapping generations economy in which limited communication and stochastic relocation creates an endogenous transactions role for fiat money. We find that when the shocks are real, welfare is higher under money growth targeting; when the shocks are nominal and not large, welfare is higher under inflation rate targeting. While under inflation rate targeting, it is always optimal to pursue an expansionary policy, it is never optimal to do so under money growth targeting.

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File URL: http://www.econ.iastate.edu/sites/default/files/publications/papers/paper_12355_05016.pdf
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Paper provided by Iowa State University, Department of Economics in its series Staff General Research Papers with number 12355.

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Date of creation: 10 May 2005
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Publication status: Published in Journal of Economic Dynamics and Control, April 2008, vol. 32 no. 4, pp. 1273-1311
Handle: RePEc:isu:genres:12355
Contact details of provider: Postal: Iowa State University, Dept. of Economics, 260 Heady Hall, Ames, IA 50011-1070
Phone: +1 515.294.6741
Fax: +1 515.294.0221
Web page: http://www.econ.iastate.edu
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  1. Gaetano Antinolfi & Elisabeth Huybens, 2000. "Monetary Stability and Liquidity Crises: The Role of the Lender of Last Resort," Econometric Society World Congress 2000 Contributed Papers 1156, Econometric Society.
  2. Champ, B. & Snith, B.D. & Williamson, D.S., 1991. "Currency Elasticity and Banking Panics: Theory and Evidence," RCER Working Papers 292, University of Rochester - Center for Economic Research (RCER).
  3. Diamond, Douglas W & Dybvig, Philip H, 1983. "Bank Runs, Deposit Insurance, and Liquidity," Journal of Political Economy, University of Chicago Press, vol. 91(3), pages 401-19, June.
  4. Townsend, Robert M, 1987. "Economic Organization with Limited Communication," American Economic Review, American Economic Association, vol. 77(5), pages 954-71, December.
  5. Gaetano Antinolfi & Todd Keister, 2003. "Discount Window Policy, Banking Crises, and Indeterminacy of Equilibrium," Working Papers 0305, Centro de Investigacion Economica, ITAM.
  6. Poole, William, 1970. "Optimal Choice of Monetary Policy Instruments in a Simple Stochastic Macro Model," The Quarterly Journal of Economics, MIT Press, vol. 84(2), pages 197-216, May.
  7. Beatrix Paal & Bruce D. Smith, 2001. "The sub-optimality of the Friedman rule and the optimum quantity of money," IEHAS Discussion Papers 0113, Institute of Economics, Centre for Economic and Regional Studies, Hungarian Academy of Sciences.
  8. Aubhik Khan & Robert G. King & Alexander L. Wolman, 2000. "Optimal monetary policy," Working Paper 00-10, Federal Reserve Bank of Richmond.
  9. Stacey L. Schreft & Bruce D. Smith, 1994. "Money, banking, and capital formation," Working Paper 94-05, Federal Reserve Bank of Richmond.
  10. N. Gregory Mankiw & Ricardo Reis, 2002. "What Measure of Inflation Should a Central Bank Target?," Harvard Institute of Economic Research Working Papers 1984, Harvard - Institute of Economic Research.
  11. Bhattacharya, Joydeep & Haslag, Joseph & Russell, Steven, 2005. "The role of money in two alternative models: When is the Friedman rule optimal, and why?," Journal of Monetary Economics, Elsevier, vol. 52(8), pages 1401-1433, November.
  12. Collard, Fabrice & Dellas, Harris, 2005. "Poole in the New Keynesian model," European Economic Review, Elsevier, vol. 49(4), pages 887-907, May.
  13. Charles T. Carlstrom & Timothy S. Fuerst, 1995. "Interest rate rules vs. money growth rules: a welfare comparison in a cash-in-advance economy," Working Paper 9504, Federal Reserve Bank of Cleveland.
  14. Smith, Bruce D, 1988. "Legal Restrictions, "Sunspots," and Peel's Bank Act: The Real Bills Doctrine versus the Quantity Theory Reconsidered," Journal of Political Economy, University of Chicago Press, vol. 96(1), pages 3-19, February.
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